Why the Economy Grows Like Crazy Amid High Taxes

The real-world effects of tax policy are counterintuitive.

They run exactly opposite the conventional wisdom. They defy what the Heritage Foundation calls common sense and what the American Enterprise Institute calls logic.

Reality laughs at the Laffer curve, calls Ronald Reagan wrong and says George W. Bush is a loon.

High marginal tax rates correlate with economic growth.

Examples include World War II and the Truman-Eisenhower years, when it was around 90 percent, and the Clinton years, when it was high relative to the preceding and following administrations.

Tax rate increases are followed by real economic growth.

Examples include Hoover in 1932, Roosevelt in 1936 and 1940, Bush the Elder in 1991 and Clinton in1993.

Moderate tax cuts are followed by a flat economy.

This is a generalization from one example: Johnson in 1964.

Large tax cuts are followed by a boom, a bubble and a crash.

1929, 1987 and 2008 are examples.

These are covered in more detail in the first part of the article "Tax Cuts: The B.S. and the Facts."

Why do high taxes create a stronger economy?

I used to run a small business -- a commercial film production company.

Every time we took a dollar out as personal income, it instantly turned into 50 cents.

If we didn't really need the money, that was an incentive to keep it in the company and to find ways to spend it that took it out of the taxable profit column but increased the value of the company.

High taxes create an incentive to reinvest profits into long-term growth.

With high taxes, the only way to retain the bulk of the wealth created by a business is by reinvesting it in the business -- in plants, equipment, staff, research and development, new products and all the rest.

The higher taxes are (and from 1940 to 1964 the top rates were around 90 percent), the more this is true.

This creates a bias toward long-term planning.

If a business is planning for the long term, it wants a happy, stable work force. It becomes worthwhile to pay good wages and offer decent benefits.

Low taxes create an incentive for profit taking.

It is easy to confuse profitability with wealth creation.

They are not the same.

President Eisenhower built the interstate highway system. There is no doubt that this gave the country an asset of great value, one that was very productive. It created great "wealth." But, aside from the construction companies that contracted the work, it was not profitable.

Selling subprime mortgages, trading in derivatives, packaging mortgage-backed securities and "flipping" condos were all very profitable but did not create wealth.

The theory is that if the rich can keep their money, they will invest in businesses that create jobs, more businesses, more tax revenue and greater "wealth" for the nation.

That sounds like logic and common sense. But is it, in practice, what happened?

Once tax cutting began, the culture of business changed.

It was no longer enough for a business to be a reasonably good business, making steady, reliable profits.

Indeed, that became a very bad condition for a business to be in. It made it a target for takeovers by people who were willing to milk them of their profits.

Among the ways you can get more profit out of a going business are:

• Cutting the workforce -- possibly sacrificing long-term productivity
• Cutting salaries -- who cares if the employees are unhappy? The balance sheet improves.
• Selling off assets -- who cares what happens in 10 years? We can take the money now.
• Outsourcing -- which sends the "wealth" somewhere else.

A whole host of devices were developed to do all of the above: junk bonds, leveraged buyouts, hostile takeovers, greenmail and the like.

Lots of money could be made that way -- for a small number of individuals. But it doesn't produce "wealth."