Why higher taxes (on the wealthy) won't slow growth: the proof is in the history.

Steve Forbes's flat-tax candidacy vaulted him to the covers of Time and Newsweek--and will almost certainly affect the tenor of the debate between President Clinton and Bob Dole in the fall. But Forbes's tax scheme is really just new packaging for an old Republican idea: large tax cuts heralded as a panacea to all the economy's ills. Remember Ronald Reagan's promise in 1981 that massive tax cuts would eliminate the federal deficit by 1984 and yield a surplus of $29.9 billion two years later? Instead, by 1984, the deficit had reached $185.4 billion. By 1988, the federal debt had swollen to $2.6 trillion.

And yet, the belief that tax cuts stimulate production--and thus flood the Treasury with revenue--remains an article of faith among supply-siders such as Forbes, Jack Kemp, and Delaware Senator William Roth. The most resolute champion of supply-side economics is Jude Wanniski, a fon-ner editorial writer for The Wall Street Journal and the force behind Forbes's candidacy. Wanniski, in fact, is the theory's progenitor, having used economist Arthur Laffer's famous curve as its theoretical underpinning. The Laffer curve shows that at some level of taxes (never specified) any further increase in taxes is counterproductive-decreasing rather than increasing the government's revenue--because it provides a disincentive to work and productivity.

In short, the supply-side theory is this: People work and invest because they are motivated to maximize their income and wealth. But taxes detract from both income and wealth, and therefore discourage work and investment. Consequently, cutting taxes stimulates work and investment, leading to more output, a healthier economy, and a better lot for everyone-including the tax collector.

Why, you might ask, do supply-siders focus on cutting taxes on the wealthiest Americans, through reductions in capital gains taxes and in the marginal tax rate for the top income bracket? They believe that savings is the key to new investment and greater output. And upper-income families, they point out, do the most saving. This is the rational for "trickle-down economics," which John Kenneth Galbraith once called the principle of giving horses more hay to feed the sparrows.

There is no laboratory in which economic theories can be tested. We can only look, in the words of John Stuart Mill, to experiments "cast up by history." And so, in the spirit of historical inquiry, I set out to compare a century's worth of data on economic growth with the marginal tax rates on the top bracket of income and the capital gains taxes in the same periods. Wading through the data might not be as fun as beach-blanket bingo, but the question at hand is a crucial one: Do lower taxes correlate with higher rates of growth? Unfortunately for the supply-siders, the numbers contradict their theory. The fact is that high income tax rates and healthy growth have often coexisted; so have high capital gains tax rates and growth.

Depressing Data

Modern day income taxation began in 1913 with the adoption of the 16th Amendment to the Constitution, which allows the federal government to tax income. The 81 years from 1914 through 1994 included all of the turbulent upheavals of this century--World War I, the Great Depression, World War II, the Korean War, and the Vietnam War--and dramatic fluctuation of tax rates. But there were 11 periods during which the tax rate for the top personal income bracket was about the same. The longest of those periods was 18 years, the shortest one year. Those 11 periods are the key to testing the supply-side theory.

The numbers show two things quite clearly: First, more often than not, tax rates and growth rates move in the same direction--in other words, higher taxes accompany higher growth, and vice-versa. Second, the relationship between changes in tax rates for income and capital gains and economic growth is extremely weak. In other words, considered over history, changes in the top bracket rate don't seem to make much of a difference to the economy as a whole.

Let's start with the "Roaring Twenties," 1922 to 1929. Supply-siders regularly use this period to buttress their arguments, since tax rates on top bracket families were cut by 57 percent over these seven years and real growth averaged a healthy 4.5 percent annually. But keep in mind that this was also the period of a strong recovery from the exceptionally severe depression, which reached its low point in 1921. Real output dropped by a cumulative 16.4 percent from 1919 through 1921, but this was followed by a robust recovery over the next two years. If we remove the recovery years from the picture, the economy's real growth rate for the remainder of the Roaring Twenties was 3.6 percent. This is a good figure, but not exceptional; it's about the same as the long-term historical average of about 3.5 percent (measured since 1893).

The 1930s brought the Great Depression--and more news to warm supply-siders' hearts: an apparent relationship between an increase in tax rates and a decline in growth. The first sharp downturn, the October 1929 stock market collapse, came on the heels of a sharp tax increase pushed through Congress by Herbert Hoover. Output declined 33.9 percent from 1930 through 1933.

Then, in 1934, the economy began to recover. Over the next three years, real output grew at an astonishing annual average of 11 percent. Encouraged by this growth, the Roosevelt administration in 1936 raised the top bracket tax rate to 79 percent hoping to balance the budget. The result was a disaster: The recovery ended abruptly. Real output fell by 5 percent in 1938, and another 8.6 percent the next year. Again, on the face, the 1930s would seem to confirm supply-side theory. But the Hoover and Roosevelt tax increases, while bad policy because they exacerbated declines in output, did not cause those declines.

The third crucial period for testing supply-side economics is the "Reagan Revolution"--1982 to 1986. Reagan entered office promising sweeping tax cuts, and he delivered--particularly for those in the top bracket, who saw their rates decline 29 percent. As I've noted, Reagan's promise that increased output would bring in more tax revenue and balance the federal government's budget turned out to be a false one. Still, supply-siders find solace in the fact that the annual average growth rate increased in these years compared to the previous 18. The increase, however, was a minuscule 0.3 percentage points. If you factor out the unintended Keynesian effect of Reagan deficits on the economy, the growth rate is entirely negligible.

So, only one of these three periods--the 1920s--offers much solace for supply-siders. The 1930s are inconclusive. And in Reagan's first six years in office the economy grew only moderately, despite massive priming of the pump through defense expenditures and tax cuts.

If you follow this sort of analysis through each of the 81 years from 1914 to 1994, you find much the same story. Eliminating both world wars and the transition years immediately following each war, we are left with 69 years in which history has cast up "experiments" for testing supply-side theory. In 55 of those years--40 percent of the time--higher top bracket marginal tax rates are associated with higher growth rates--not lower ones.

Consider the period between 1950 and 1963. Today there is much nostalgia for this time, but not among supply siders. After all, the top bracket marginal tax rates were higher than at any time in the post-World War II (91.1 percent). At the same time, the annual average growth rate hit a postwar high of 3.8 percent. Even excluding the Korean War years, when a new surge of military spending pushed real growth up to an 8.5 and 10.3 annual rate, the fifties' growth rate averages 2.8 percent--the same as during the Reagan '82 to '86 period. This growth coexisted with extraordinarily high tax rates.

The history of changes in capital gains taxes is even more unfavorable to supply-side theory. For five of the seven periods following 1921, the relation between an increase in the capital gains tax and growth was a positive one--they both went up; this was true 52 of the 73 years after 1921. The rate went up and growth went down in only two periods.

The problem with capital gains tax cuts is not just that the numbers contradict the supply-side hypothesis. It's also nearly impossible to devise a capital gains tax break that truly rewards enterprise, as opposed to mere speculation. As Keynes explains in his classic, The General Theory of Employment, Interest, and Money, enterprise involves the production of new, real wealth, such as starting a new business, building a new factory, or developing a new product. Speculation, on the other hand, involves an increase in the monetary value of things that already exist; this adds to the wealth of individuals, but not to the real wealth of the nation. The reality is that existing practices in the taxation of capital gains reward speculative activity as much as they do enterprise activity. And, ultimately, it is the bulk of Americans who suffer from the lost tax revenue. The Reagan tax cuts, remember, weren't just a failed experiment in that they failed to produce the promised growth. They also saddled us with so much debt that 15 percent of the annual federal budget is consumed entirely with interest payments.

Despite this evidence, we can be nearly certain that the supply-side fantasy will continue to command attention in the Republican party. Bob Dole, to his credit, is skeptical of supply-side arguments. His reluctance to embrace tax cuts, in fact, is what got Steve Forbes into the race to start with. Even though he's conceded the race, Forbes is unlikely to concede the validity of the evidence laid out in this article. But that's no reason for the rest of the population to be taken in.

This argument is not merely about numbers, of course. It's also about psychology. Supply-siders would have us believe that people are driven to work and achieve solely by the desire to accrue money, but that is clearly not true. If they had to pay more in taxes, would Steven Spielberg, George Soros, or Bill Gates work less hard? Of course not. These men--like most Americans --are driven not just by monetary reward but also by prestige, power, and genuine love of their work. Furthermore, a dollar earned but taxed heavily is still more than nothing. Ronald Reagan's acting income was taxed at 91.1 percent--a rate no one would dream of enacting today--but he not only didn't turn down any good roles, he also made all those monkey movies. Yes, Forbes, Wanniski, Kemp et al. will keep rambling on about the flat tax. But the numbers--and theory--of supply-side arguments just don't add up. Now it's as clear as ever: Snake oil remedies are still snake oil, and voodoo economics is still voodoo economics.

Wallace C. Peterson is the George Holmes professor of economics emeritus at the University of Nebraska, Lincoln and is the author of Silent Depression: Twenty-five Years of Wage Squeeze and Middle-Class Decline.