Marginal Tax Rates and Unemployment

This is an interesting article by Joshua A. Cuevas from Counterpunch

                “Unemploymentand Marginal Tax Rates”

When the top marginal tax rates are compared to unemployment rates for the same year, one year later, two years later, and three years later, nearly identical results emerge. Not only is there a negative relationship in each case, with low tax rates correlating with high unemployment and vice versa, the magnitude of each relationship is nearly identical. So between 1948 and 2011, there appears to be a clear and consistent relationship between top marginal tax rates and the unemployment rate. And since unemployment rates cannot dictate tax rates, any influence must go in the opposite direction, with tax rates influencing the unemployment rates. Because we are dealing with correlations, there is a possibility that a third variable or more variables are also at play, particularly in a dynamic as complex as the U.S. economy. Indeed, it is almost a certainty that other factors are involved. But the unmistakable and highly uniform pattern revealed in the analyses reported here would lead us to believe that the relationship between top marginal tax rates and unemployment is in fact present, even if other factors are also involved.

What we can say with absolute confidence, though, is that there is no evidence here that low tax rates are associated with low unemployment, and by extension, a healthy economy. Similarly, there is no evidence that high tax rates are associated with high unemployment, and by proxy a weak economy. There is simply no empirical basis to make those claims based on this historical data. In fact, everything we see here suggests that just the opposite is true. Low marginal tax rates do not appear to be beneficial to employment rates, and if they are in fact detrimental to employment rates one would be hard pressed to make the case that they are helpful to the economy. In the most basic terms, a healthy economy is one in which the vast majority of citizens who want to work can find that work.

If one were to accept the common contention these days that we must wait until we again have a strong economy before we are able to collect the tax revenues needed to adequately fund public sector services, the data simply does not support that claim. These numbers tell a far different story. They instead suggest that while tax rates remain at historical lows we will continue to have a weak economy and high unemployment. There is no data to suggest that by keeping top marginal tax rates low it will improve the economy or decrease unemployment. For those who insist on low taxes at all costs, it would be worthwhile for them to look at the numbers and realize that pursuing low marginal tax rates, and gutting education and other social services in the process, is not the answer to a weak economy. It may be one of the causes of it, and certainly appears to be a prime factor in the equation. If we continue on the trajectory that we as a country have been on for more than 30 years of demanding lower and lower tax rates in the hopes that it will keep money in our pockets and food on the table, the data tells us we are more likely to have empty pockets and less on the table.

 

So let’s think about the intuition behind this. How could higher tax rates theoretically encourage employment? If tax rates are higher, the opportunity cost of hiring someone is smaller, and therefore, a higher top marginal tax rate may encourage hiring, not discourage it as popularly thought.

Let’s say a business person is deciding whether or not to hire someone or just do the work themselves. Hypothetically we will assume this business owner makes $300,000 per year. Let’s assume their tax rate is 25%.

If they pay someone $40,000/year the opportunity cost is salary - salary*tax rates = $30,000. This is what the employer would have netted after taxes had he not hired someone.

Now let’s assume tax rates are 40%. The opportunity cost then would be salary – salary*tax rates = $24,000, which is much lower than $30,000.

This is basically the same intuition behind IRA contributions rising when tax rates rise as well.