Taxes and Growth

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Ross Douthat says that “conservatives need to accept that taxes will probably go up somewhat relative to the post-World War II average” but he still wants to lean against this trend because “[w]hatever the differences between the Scandinavian experience and our own, as a general rule tax increases tend to dampen economic growth.”

Obviously this isn’t a question that one is going to resolve in a single blog post, but I really think it’s mistaken in a way that gets to the core of how so much of our political debate is basically besides the point.

Think about it this way: Grant to the tax skeptic all he wants about the idea that high taxes reduce the level of economic output. There’s an easy story to tell here. The quantity of economic output is, in part, a function of how much time and effort people want to put into doing market production. And the amount of time and effort any given person wants to put into market production is in part a feature of how much purchasing power extra time and effort put into market production will get him. Higher taxes—either on his labor or on his consumption of goods and services—reduces the purchasing power of extra time and effort on market production, and thus tend to reduce the amount of time and effort people put into it. You can tell a different, more leftwing story about this, but the point I want to make here is simply that this rightwing story about taxes and output is a story about levels not growth rates. If Americans started working the number of hours per year that South Koreans work, our per capita GDP would go way up.

But that’d be a one time adjustment. Countries don’t grow over time by steadily increasing their number of hours worked. They grow, roughly speaking, because people think up better ways to do things and then businessmen either adopt those new better methods or else they get put out of business by those who did.

And what do taxes, really, have to do with this? It’s hard to tell a story. If someone invents a new, radically more efficient way of retailing over the counter medicine then CVS is either going to adopt that method or else it will be driven out of business. If America shifted to Swedish levels of taxation, it’s not like the company’s CEO would spontaneously forget that he’s supposed to try to cut costs and increase profits. But Sweden’s not just a land of high taxes. Until July 2009 it was also a country with a government run monopoly on over the counter medicine retailing. That is the kind of policy that could prevent the adoption of best practices. CVS will either adopt promising new methods, or else it’ll go out of business. But while a monopolist might adopt promising new methods, it also might not. And if it doesn’t, it won’t go out of business.

That’s bad stuff and that’s why it was smart of Sweden to drop that policy. But these are the kind of initiatives that we should be looking at for pernicious growth impacts. Not so much state-owned firms (which are very rare these days) but the copious instances of incumbent firms trying to use their political clout to limit competition. Those limits on competition prevent the emergence and adoption of new, smarter, better ways of doing things and thus reduce our economy’s ability to grow.