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How Do Tax Rates Affect the Economy?

Supply-side economists like to make a direct link between tax rates and economic growth. Forbes magazine's Ben Wilterdink, in a 2013 article, explains, "Rather than driving up rates on a small number of overburdened taxpayers, these states create an environment where people and businesses can flourish. This attracts more people and businesses to the state, which in turn allows the state to grow its revenue by virtue of having a larger population paying taxes." Wilterdink argued that a state that lowers its marginal income taxes experiences growth in three ways: More new businesses are formed, more existing businesses relocate to the state, and more able-bodied workers move to the state.

But fast forward a couple years, and the picture is not so clear. The state of Kansas, after reducing tax rates in 2013, has experienced slower than average job growth.

After the tax cuts became law in January 2013, the number of Kansas’ private sector jobs went up only 2.5 percent through November 2014.

That was below 37 other states (including Missouri) and Washington, D.C.

Minnesota, meanwhile, has one of the best job-growth rates in the nation, despite raising taxes over the last four years.

Even though Minnesota's top income tax rate is the 4th-highest in the country, it has the 5th-lowest unemployment rate in the country at 3.6 percent. According to 2012-2013 U.S. census figures, Minnesotans had a median income that was $10,000 larger than the U.S. average, and their median income is still $8,000 more than the U.S. average today.

Can we then conclude that tax increases boost economic growth? No. Two data points cannot determine a trend.

A 2010 Slate article by Eliot Spitzer dug into the numbers. It was easy to find anecdotal evidence that higher taxes stifled economic output.

President Reagan is famously reported to have observed that, as an actor, once he hit the top marginal rate—then 91 percent—he stopped making movies for the rest of the year.

On the other hand, statistical correlation was elusive.

An excellent review of this in the Yale Law Journal, "Why Tax the Rich? Efficiency, Equity, and Progressive Taxation," concludes that there is scant, if any, legitimate academic support for the proposition that moderate, as opposed to dramatic, increases in marginal rates have any impact on the willingness of the wealthy to participate in the economy.

The reality is, many factors contribute to economic growth, and most of them are beyond politicians' control. But the politicians will probably continue railing about taxes as long as it wins votes.

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