Much discussion has happened on this site regarding income tax rates, government spending, and the health of the economy. Certainly I’ve had some preconceived notions of what’s best, as has pretty much everyone else here.
I decided to be more open-minded and run a more thorough analysis of the relationships among taxes, government spending, and the economy. I collected data on GDP, government revenues, and government spending, from 1913 to 2008. I also collected data on inflation and population, so that I could normalize the results against changes in the real value of nominal dollars, and against the inherent growth effects that result from larger populations. I chose 1913 as the starting year because it was the first year of the federal income tax.
In some cases, I have normalized government revenues and spending as a ratio to overall GDP. Where I did this, the intent is to recognize that the effect on the economy of government collecting taxes or spending money will necessarily be related to the size of the levies and expenditures relative to the overall economy. That is, government spending $1B in a $3B economy should be expected to have a substantial impact, while spending the same $1B in a $3T economy should be expected to have minimal impact, being a thousandth as much a part of the economy.
In all cases, I looked at GDP in the same year as inputs, as well as one to five years offset, to account for the time it takes for economic impact to propagate throughout the economy.
I performed regression analyses against a number of possible inputs, looking for a statistically significant correlation between the input and the output of year-over-year change in per-capita GDP in real dollars (i.e., adjusted for inflation).
It took numerous iterations, which I will be happy to explain if I’m asked to, but I don’t want to bore you with the details otherwise. Perhaps a sidebar article is in order, if you all want to read it.
The most significant correlations I found were when combining spending as a percentage of GDP at an offset of two years (S%GO2), and income tax as a percent of government revenues with an offset of one and two years (IT%RO1 and IT%RO2). The combined R2 was 0.36, indicating that these combined inputs accounted for 36% of the variance in GDP growth. The spending coefficient was 0.26, meaning that each increase of 1% in government spending relative to GDP corresponded to an increase of roughly 0.26% in GDP growth two years later. Oddly enough, the coefficients for income tax as a percent of government revenues were nearly equal but opposite for offset years one and two. That is, for a one-year offset, higher percentages of government revenues coming from income taxes corresponded to a decrease in GDP growth, while the opposite is true for a two-year offset. You can see what I mean in the below table.
|Coefficients||Standard Error||t Stat||P-value||Lower 95%||Upper 95%|
I could find no statistically significant correlation between GDP growth and any of the following:
- Income tax as a percentage of GDP
- Overall tax revenues as a percentage of GDP
- Non-income tax revenues as a percentage of GDP
- Deficit spending as a percentage of GDP
- Bottom and top income tax rates
I also tried including and excluding the size of the national debt as a percentage of GDP. While the size of the national debt was borderline statistically significant, it had a tiny R2 (0.003) and it didn’t impact the multivariable regression analysis.
I ran one other set of tests, looking for a correlation between increases in government spending and changes in private sector spending. Specifically, I was looking for evidence that increased government spending crowds out the private sector, a theory that has been brought up repeatedly in the comments on this site. Again, I looked at offsets from zero to five years. For this set, because income tax was not important, I went from 1794 to 2008, so as to have more data points. I could find no statistically significant relationship between the two.
The regression analysis suggests that the most important thing the federal government can do to improve the economy (among the fiscal levers of spending, taxing, and running deficits) is to spend money. It doesn’t matter whether it’s spending money collected via taxes or created via deficit spending.
So, based on nearly a century of data, we can conclude that there is statistically significant evidence to support the hypothesis that Keynes was right, at least within the range of values experienced over the past century. More government spending corresponds to more growth in the economy.
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