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The · Psychohistorian

Taxes and growth

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I posted last fall on why increasing taxes on those making over $250,000 - mostly professional couples, like two doctors who are married - was likely to reduce tax revenues rather than increase them. Since then, the focus has turned to a higher income category - those making more than $1,000,000 or so per year - though still not to the super rich, who make most of their money through capital gains and don't pay anywhere near the top tax rate.

So who are the people who make more than $1,000,000 a year in regular income? Well, a few are people who get lucky with a bestselling book or the like. However, most are probably owners of subchapter S corporations. Subchapter S corporations are small to medium sized businesses that use simplified tax rules where the corporate income is reported on the owner's income tax return and taxed at the owner's rate. S corporations that net over $1,000,000 a year include growing businesses which have not yet fully matured - businesses like Bertucci's and Boston Chicken while they were still privately owned, before they became big enough to go public or sell out to national corporations.

Where does this money go? Well, some of it is distributed to the owners for their own personal use. The rest stays with the business for reinvestment into growth - and job creation. From a tax policy standpoint, the question is, do taxes come out of the part distributed to owners, or do they come out of the part that's used for business growth and job creation? Obama apparently thinks it's the former, and advocates raising the rates substantially since he thinks that would only hurt the owners. Paul Ryan seems to believe the latter, and his budget plan removes tax loopholes and cuts the marginal rate substantially, in the hopes that will improve economic growth.

We now have some evidence on this issue. The top marginal rate, on income above about $380,000, was set to increase by 4.5% at the end of 2010, and small businesses were likely making their plans on that basis. However, at the beginning of December, the previous, lower tax rates were extended. If Obama was right, this shouldn't have affected hiring; if Ryan was right, we should have seen a boost in hiring and a drop in unemployment.

Here's a graph of the actual figures, showing a four month drop in unemployment rates starting sharply just as the bill to maintain the lower tax cuts passed:

graph showing sudden drop in unemployment starting December 2010

Now, there may have been factors other than lower tax rates that contributed to the fall in unemployment. For example, some people may have dropped out of the labor force when their unemployment benefits finally expired. Indeed, in December and January, there were continued drops in the labor force, as there had been in the previous two months.

However, even in December and January, there was a net increase in total employment, so there was at least some real improvement in the employment picture. The February and March improvements were entirely job creation. In addition, the underemployment rate fell during each of those four months, so not only are there new full time positions being created, but some part time positions are also being upgraded.

Overall, the numbers make a pretty convincing case that lower marginal tax rates do in fact help generate employment growth.

The original data is available at:
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On April 27th, 2011 09:14 pm (UTC), llennhoff commented:
I was under the impression that unemployment was a lagging economic indicator, not a coincident one.
[User Picture]
On April 27th, 2011 09:23 pm (UTC), psychohist replied:
Indeed it is. That's why we see unemployment continuing to decline four months after the event - and also why I didn't have the data to make this post four months ago.

What's coincident is the signal in the second derivative of the unemployment rate. Derivatives of a lagging indicator need not themselves be lagging indicators.
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