Do Low Tax Rates Really Encourage Investment?

Now that Republicans have taken control of both houses of Congress there is once again talk of boosting the economy by cutting taxes.

It made me realize that in the 20 years or so I have been reading the Economist I have regularly seen the assertion that low taxes encourage investment, sometimes by the Economist quoting Republicans, sometimes by the Economist theorizing or editorializing.  But I have never seen any data to support the assertion.

Looking back over the last 40 years I have a harder and harder time accepting that assertion as true, and am certain it is not true for all situations.

Recent economic history has made it pretty clear that the theories of human motivation that the science of economics has been rooted in is to reality what a stick figure drawn by a 5 year old is to the reality of human anatomy.  This assertion that low taxes encourage investment is beginning to look to me like economic theory based on this stick figure understanding of human motivation.  It assumes every person is motivated by money above all, and that nobody ever feels like they have enough money to focus on other things.

This assumption doesn't square with my life experience or research findings I have seen.  

A research study from a couple years ago found that for most people about $70,000 a year is enough, beyond that figure money doesn't  motivate them.  I'm sure there are people who want far more, but I can't imagine that there is anyone that doesn't have a point where they feel their needs and wants are met, at least in what money can buy. So for most humans who reach the point where they have enough, if they continue working it is not for the money.

So what is it?  I think there are lots of potential explanations.

I came out of law school just about the time Ronald Reagan took office.  Within a couple years he started the rash of tax cuts that have characterized the last 40 years of government policy.  When I first started practicing law lawyers expected to make good money, but it was only part of the reward.  As they built up their practice they hired staff so they could work reasonable hours and have a life as their practice expanded.

I left the practice of law nearly thirty years ago, but am in touch enough to know the practice has changed dramatically.  It is all about money.  To compete big law firms require their lawyers work incredibly long hours.  The have downsized the amount of support staff enormously.  In the law business it is pretty clear to me the primary result of tax cuts has been longer hours for those driven to succeed, layoffs of the staff that used to lighten their load, and more money in the pockets of the most driven individuals.

For the lawyers in big firms I don't think it is all about the money.  It is about prestige, accomplishment measured against your peers.  To the extent it is about the money its not fundamentally about what they want to buy, it is that how much money you have is the marker of how successful you are.  

Back in the early 1950's, partly to pay off the debt of WW II, Congress created really high tax rates for people that made a lot of money.  If you were hauling in vastly more than most other people each year the dollars at the top end your pile of money were taxed at 70, 80 or even 90% of what you took in.

The logical response of the very wealthy at that time was to limit the amount of money they took in personally, so they focused on building empires.  They hired lots of people, started new companies.  Instead of paying high taxes to Uncle Sam they plowed money into building for the future.  The following couple decades are now viewed by economists as the golden years.  Low unemployment, high wages, a health economy.

Contrast that with the last couple decades of boom and bust and asset inflation.  Big companies are currently rolling in money but they are generally not hiring or starting new businesses, they are kicking out the money in enormous salaries for the top executives, or using stock buy-backs to pump up their stock price, making both the top management and shareholders wealthier.  Low taxes on individuals make this an economically rational choice.

Individual wealthy people also generally aren't starting new businesses and hiring people.  They are trading in stock, real estate, art, classic cars - building their personal wealth and in the process inflating asset prices.  The assets aren't improved, no value is added.  The price just keeps going up because the people with lots of money are swapping them back and forth, both as an easy, low maintenance way to store your money, and as a way to  evidence their high status in society.  But it is not generating productive economic activity.  

It seems to me our tax cutting policies of the last 40 years have stood motivation on its head.  The 1954 Tax Code, with its high marginal rates discouraged what I would describe as frivolous earning and spending to encourage people to invest in real productive activity.  The 1954 tax code also had a provision called income averaging, so the people who were just making lots of money for the first time could average their income over the last five years for tax purposes.  This provided a ladder for people to get up to that position of comfort before the really high tax levels kicked in.   Income averaging disappeared with the Reagan tax cuts in the mid-1980's.

I think if we really want to rebuild an economy that works for everyone we need to start looking at high personal tax rates that kick in at some point on the income scale to make overbuilding your short term personal fortune less attractive than building long term investments.