American Economic Association Tax Policy and Economic Growth: Lessons From the 1980s Author(s): Michael J. Boskin Source: The Journal of Economic Perspectives, Vol. 2, No. 4 (Autumn, 1988), pp. 71-97 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1942778 Accessed: 05/01/2010 02:01 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. 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Few would have guessed in 1980 that inflation would fall rapidly to 4 percent and hold pretty steady during a lengthy recovery, that productivity growth would partially rebound, the national debt more than double, capital imports reach $150 billion in a single year, or that employment would continue to expand at rates envied by other advanced economies. Perhaps fewer still would have predicted two major and two minor tax reforms would be passed in six years, a flip-flop in depreciation schedules, and a top personal tax rate below 30 percent. While it is always easier to draw inferences concerning economic growth, its determinants, and policies affecting the determinants with long historical hindsight, this paper will attempt to provide information, evaluation, and conjecture to draw some tentative lessons about the effects of tax policies in the 1980s on long-run economic growth. The good news from the 1980s is the remarkable achievement of substantially lower marginal tax rates, making the government a much smaller silent partner in many economic decisions. For example, the tax advantage of debt finance is reduced substantially with the much lower marginal tax rates. The bad news is that the nation could not afford all of the good news. The very large budget deficits add to the instability in the tax code, in addition to whatever other problems they cause. Moreover, in a country with the lowest saving and investment rates in the advanced world, the consequence of which may be to decrease our long-run growth potential and short-run trade competitiveness, the remaining anti-saving and investment fea- tures of our tax law, while probably less important in the long run than the U.S. * MichaelJ. Boskinis WohlfordProfessor of Economicsand Director, Center for EconomicPolicy Research,Stanford University, and Research Associate, National Bureau of EconomicResearch, all at Stanford,California. 72 Journalof EconomicPerspectives budget deficit, will eventually require serious attention. The lessonof the 1980s is not that we should dramaticallychange the new tax laws but ratherthat we should build on their accomplishments:broaden the tax baseto includemore consumption while preserving low marginal tax ratesand restoringcarefully targeted incentives for savingand investment. Determinants of Growth The power of compounding even modest increases in the growth rate is enor- mous. The United Kingdom, growing at only one percentage point per year less than the United States, France and Germany, transformeditself from the wealthiest society on earth to a relatively poor member of the Common Market in less than three generations. As an illustration, consider two equally wealthy economies. In one, per capita income grows at 1.5 percent; in the other, at 2 percent. The more rapidly growing economy will be almost 30 percent more wealthy than the less rapidly growing economy in less than two generations, a difference in living standards that carries labels like "successful" and "sick," respectively. Thus, differences of fractionsof a percentagepoint in the long run growth rate must be explained in attempting to assess growth performance. Increasing the growth rate (at minimal opportunity costs) by .2 or .3 percentage points is an enormous economic and social achievement. Studies of economic growth usually attempt to decompose the rate of growth of real GNP (or some related output measure) into the contributions of various factors thought to explain it. These include such factors as increased labor input, increased capital input, improved resource allocation, and technical change. The Empirical Evidence on Growth As Table 1 demonstrates,real gross product and real product per hour worked in the United States have grown more rapidly in the period from 1981 through the first quarter of 1988 than from 1973 to 1981, but much slower than in the 1948-73 period.' Perhaps the quarter century after World War II should be thought of as an aberration, a special period of growth more rapid than is likely in the long run. What caused this history of rapid growth, a major slowdown, and the recent modest growth turnaround? The usual growth accounting framework-based on the production function F(K, L, t) where K is capital inputs, L is labor inputs, and t is time-asks how much could have been produced with the growth of inputs if technology was constant between two periods in time. The difference, the residual unexplained by input IWhile the introduction of new products is a major source of increased economic well-being and is probably undervalued in the traditional GNP estimates, and numerous other measurement issues abound as well, I take the figures in Table 1 to be representativeof the true trends. However, I have much sympathy with a Schumpeterian approach to growth emphasizing entrepreneurship.In the aggregate data, these gains are buried in investment, R&D, and other data. MichaelJ. Boskin 73 Table1 Output and Productivity Growth in the U.S. Economy (averageannual percentage rates of growth) Real ProductPer Year Real Gross Product Employee Hour 1948:IV-1973:IV 3.7 2.8 1973:IV-1981:III 2.2 0.7 1981:IV-1988:I 3.3 1.3 Source: U.S. Dept. of Labor growth, represents the shift in the production function, which is taken to represent technical change, organizational efficiency gains, entrepreneurship,improved resource allocation, and so on. Many strong assumptions are usually made to draw such inferences: for example, constant returns to scale, profit maximization and competitive markets to allow use of factor shares as weights, no aggregation errors, capital malleability, no unmeasured inputs, no deviations of marginal products from normal- ized input prices, no scale or learning effects, no measurement errors in capital or labor input prices or utilization rates. Each of these issues is the subject of much research and debate. The sources and the quantitative determinants of economic growth remain a source of major controversy.However, I think the existing literature does support this mild conclusion: Lesson 1: The best empirical growth studies suggest that the rate of capital formation and technical change have been important determinants of long-run U.S. growth. These factors also help to explain differences in international productivity growth. Therefore, the effect of tax policy on investment and technical change is important in understanding the effects of tax policy on long-run growth. When M. Abramovitz (1956) and R. Solow (1957) asked how much of the growth of output can be explained by the growth of inputs, their answer was precious little. Subsequent studies by E. Denison (1974), and others appeared to confirm this small contribution of increased labor and capital input to increased output. In particular, Denison (1979) places very little weight on the decline in the rate of growth of the capital-labor ratio as a contributing factor in the productivity growth slow- down. These authors placed a heavy emphasis on technological change as the prime determinant of economic growth. Jorgenson (1986) and others have questioned the Abramovitz-Solow-Denison finding, attributing a much greater share of postwar U.S. growth to increased capital input and much less to the unexplained residual "techni- 74 Journalof EconomicPerspectives cal change."2 In the work of Jorgenson and others, greater disaggregation and improved measures of labor quality seem to be a major reason for assigning greater weight to capital formation. As Lesson 1 states, I conclude from this evidence that both investment and innovation play a major role in determining productivity growth. In fact, as discussed below, I suspect investment and innovation are interdependent and that interdependence increases the elasticity of output with respect to capital inputs.3 Of course, saying that "innovation causes productivity"begs the question of what causes innovation. John Kendrick (1986) stresses the role of research and develop- ment. He estimates a typical lag of about six years between spending on R&D and its commercial application. He therefore attributes part of the decline in productivity growth in the 1973-81 period to a prior slowdown in R&D spending.