The Unnoticed Cost of High Taxation

More than one person has said, "I hope the government won't do anything else for me. I can't afford what it's doing for me now."

There is wisdom as well as wit in that saying. It turns out that every additional dollar federal, state or local government collects in taxes costs us $3.44 in lost national output. That means economic growth slows and people earn less money. And because the revenue base grows more slowly, in the long run government collects less in tax revenue.

All this has particular relevance today, when government taxation as a percentage of the nation's gross domestic product is at the highest point ever — even higher than during any of our wars. Governments at all levels are taking almost one dollar of every three — about 31.3% of GDP.

Economist Gerald Scully, a Senior Fellow at the National Center for Policy Analysis and a professor at the University of Texas at Dallas, has calculated that the greatest economic growth in the United States occurs — and the most tax revenue is produced in the long run — when federal, state and local governments combined take no more in taxes than about 21% of GDP. But we haven't seen that level of taxation in almost 50 years — not since 1949.

In a new study, Scully looks at the 46-year period from 1950 through 1995 and calculates that every dollar of tax collected caused an average of $1.71 in lost production. The $3.44 is what it's costing now for each additional dollar collected — that is, the marginal cost of taxation.

Paradoxically, if the tax take had remained at 21% of GDP over those years, everybody, including government, would have more money today. About twice as much. The reason: beyond a certain point, taxes impede economic growth.

At the 21% level of taxation, our economy would have averaged growing 4.8% per year over the 46 years instead of the actual rate of 3.4%. The additional 1.4% in economic growth each year would have meant the average person would have twice as much real income today, and that even with all the government programs, we would have no national debt!

Obviously, some level of taxation helps make private economic activity more productive. Such things as highways and other infrastructure, national defense, a criminal justice system to protect lives and property, and an educational system all contribute to growth.

But when governments continue to increase the tax load and use the increased amount mainly for transfer payments, it is a drag on the economy. Beyond a certain point, people have less reason to save and invest, entrepreneurs have less incentive to be innovative, workers don't work as much, and people try to avoid or evade taxes.

Scully says government in the U.S. for the last several decades has more and more tried to redistribute income — not from the rich to the poor nearly as much as from middle-class taxpayers to middle-class beneficiaries. Thus we have large groups of what the economists call rent-seekers, those who seek profit through political means that they could not obtain in a free market.

But what about the social benefits those additional tax dollars have provided? A case can be made that increased government spending up to about 1960 did lead to measurable improvement in various social indicators. However, since 1960, Scully concludes (and cites other economists who agree), increased taxes have not bought very much in terms of social progress. For instance, we have not eliminated poverty or brought the poverty rate down significantly. Criminal activity is higher. Infant mortality and the overall death rate have continued to decline, but much less rapidly in recent decades as government has grown larger. And life expectancy is increasing more slowly.

The United States certainly is not unique in having a tax level far above the growth-maximizing level. Scully found the same situation in other developed countries, especially among the European welfare states. Taxes take far more of the GDP there than in the United States. In the worst cases, such as Denmark and Sweden, the level of taxation that would maximize economic growth is less than half the level that actually exists — and the economies are in deep trouble. They can't grow with such a high level of taxation. But it's a politically difficult proposition to shrink the welfare state.

In the United States, the level of taxation as a share of GDP has crept upward for almost half a century. The failure to consider the long-term results has cost our nation a fortune — literally. We have robbed ourselves of a better standard of living for everyone.