Tuesday, May 10, 2011

Why Tax Revenues Often Don't Reflect Economic Growth

Caroline Baum argues that economic growth in the U.S. is underestimated by the official GDP numbers.

Her arguments aren't that convincing though. When she for example argues that the defense spending decline reported contradicts other reports, she seems to have missed that the other report was a forecast from March, not an estimate based of available data.

Other arguments are somewhat contradictory as she first claims that individual income tax receipts are a good way of measuring labor income and then overlooks corporate income tax receipts (which rose only 4%) when estimating corporate profits.

As it happens, there are at least two reasons why the change tax receipts may differ from economic growth. First of all, tax laws may change. And that was indeed a reason why individual income tax receipts rose sharply as the "Making Work Pay" tax credit expired and it was also the reason why social insurance tax receipts fell as the payroll tax was reduced.

Another reason is that in a system with progressive taxation, an increase in inequality will increase tax revenues relative to GDP because the incomes of the rich which face higher tax rates rise relative to the incomes of everyone else. A decrease in inequality will of course for similar reasons reduce tax revenues relative to GDP.

If you make the reasonable assumption that inequality has increased following QE2, then economic growth is a lot lower than the increase in tax revenues.