pressed about the harmful effects on the economy, proponents of higher
taxes often fall back on what can be called the "Clinton defense."
President Clinton pushed a major tax increase through Congress in 1993
and, so the story goes, the economy boomed. How then can tax increases
be so bad for the economy? The inference is even stronger--that higher
taxes actually strengthened the economy. The Clinton defense is
superficially plausible, but it fails under closer scrutiny. Economic
growth was solid but hardly spectacular in the years immediately
following the 1993 tax increase; the real economic boom occurred in the
latter half of the decade, after the 1997 tax cut. Low taxes are still
a key to a strong economy.
The Clinton Tax Defense
A growing body of literature and experience indicates that higher taxes are associated with a smaller economy.
It is generally axiomatic that the more one taxes something, the less
there is of the item taxed. There is surely no reluctance among
proponents to argue that higher taxes on tobacco materially reduce
tobacco consumption, or that higher taxes on energy would appreciably
reduce energy consumption. Yet somehow the argument persists that
raising taxes on labor does not diminish the supply of labor, or that
raising taxes on capital does not appreciably reduce the amount of
capital in the economy. In both cases, tax hikes weaken the economy and
reduce the amount of income earned by American families.
Clinton defense in favor of higher taxes largely rests on a cursory
review of the economic history of the 1990s. Whatever the theoretical
debates, the proof, as they say, is in the pudding: President Clinton
raised taxes and yet the economy grew, and grew smartly in the latter
half of the 1990s. Economists have occasionally been accused of seeing
something work in practice and then proving that it cannot work in
theory. However, this is not the case here.
History suggests the
economy performed reasonably well in the years immediately following
the tax hike, but history is not causality, and sometimes history needs
a more careful examination to tell its story faithfully. Following the
tax hike, the economy performed reasonably well, but not as well as one
would expect given the conditions at the time. The real economic boom
came later in the decade, just when the economy should have slowed as
it transitioned from a period of recovery to normal expansion. Further,
this acceleration coincided to a remarkable degree with the 1997 tax
Contrasting the period immediately after the tax hike and the period immediately after the tax cut,
the evidence strongly suggests that the tax hike likely slowed the
economy as traditional theory suggests, and that it was the tax cut
that gave the economy renewed vigor--and gave history the real 1990s
boom. The Clinton defense of higher taxes does not hold up.
The Clinton Tax Hike
In 1993, President Clinton ushered through Congress a large package of tax increases, which included the following:
increase in the individual income tax rate to 36 percent and a 10
percent surcharge for the highest earners, thereby effectively creating
a top rate of 39.6 percent;
- Repeal of the income cap on
Medicare taxes. This provision made the 2.9 percent Medicare payroll
tax apply to all wage income. Like the Social Security payroll tax base
today, the Medicare tax base was capped at a certain level of wage
income prior to 1993;
- A 4.3 cent per gallon increase in transportation fuel taxes;
- An increase in the taxable portion of Social Security benefits;
- A permanent extension of the phase-out of personal exemptions and the phase-down of the deduction for itemized expenses; and
- Raising the corporate income tax rate to 35 percent.
to the original Treasury Department estimates, the Clinton tax hike was
to raise federal revenues by 0.36 percent of gross domestic product
(GDP) in its first year and by 0.83 percent of GDP in its fourth year,
when all provisions were in effect and timing differences associated
with near-term taxpayer behaviors had sorted themselves out. In 2007,
the fourth-year effect would be roughly equivalent to an increase in
the federal tax burden of about $114 billion.
economic environment at the time of the tax hike is important in
assessing its consequences. In January 1993, the economy was entering
its eighth quarter of expansion after the 1990-1991 recession. The
recession had been relatively mild by historical standards, with a net
drop in output of 1.3 percent. Yet even at the start of 1993, the
economy was operating below capacity. Capacity utilization in the
nation's factories, mines, and utilities was running at about 81
percent, whereas it had been around 84 percent through much of 1988 and
1989. The unemployment rate in January 1993 was 7.3 percent but had
averaged 5.3 percent as recently as 1989. At the time of the tax hikes,
the economy was recovering, but still far from healthy.
policy aside, much in the context of the 1990s was conducive to
prosperity. The end of the Cold War brought a new sense of hope and
greater certainty to the global economy. The price of energy was
astoundingly low, with oil prices dropping to about $11 per barrel and
averaging under $20 per barrel compared to prices above $90 per barrel
today. The Federal Reserve had finally succeeded in establishing a
significant degree of price stability, with inflation averaging less
than 2 percent during the Clinton Administration. And, of course, a
tremendous set of new productivity-enhancing technologies burst on the
scene involving information technologies and the World Wide Web.
a major negative shock, one should have expected a period of unusually
strong growth from 1993 onward as the economy more fully employed its
available capital and labor resources. In the four years following the
Clinton tax hike (from 1993 through 1996):
- The economy grew at an average annual rate of 3.2 percent in inflation-adjusted terms;
- Employment rose by 11.6 million jobs;
- Average real hourly wages rose a total of five cents per hour; and
- Total market capitalization of the S&P 500 rose 78 percent in inflation-adjusted terms.
statistics indicate a solid, but not spectacular, performance in the
overall economy. Job growth was strong, as one would expect coming out
of recession. Real wage growth remained almost non-existent, and the
stock market performed well. But the real question is this: Altogether,
did the economy perform better, or worse, because of the tax hike? The
data from the period do not provide a clear answer.
1997 was a watershed for both tax policy and the economy. By 1997, the
economy had entered into a sustained expansion. The unemployment rate
was 5.3 percent, a level thought at the time to be roughly consistent
with full employment. Similarly, capacity utilization rates hovered
around 82.5 percent; again, roughly consistent with full employment of
the nation's industrial capacity. With a mature expansion and the
economy running at what was believed to be about full capacity, growth
would normally be expected to ease back as the economy transitions from
recovery to normal growth. It was not a moment one would expect growth
The 1997 Tax Cut: The Economy Unleashed
1997, the Republican-led Congress passed a tax relief and deficit
reduction bill resisted, but ultimately signed, by President Clinton.
The 2007 bill:
- Lowered the top capital gains tax rate from 28 percent to 20 percent;
- Created a new $500 child tax credit;
- Established the new Hope and Lifetime Learning tax credits to reduce the after-tax costs of higher education;
- Extended the air transportation excise taxes;
- Phased in an increase in the estate tax exemption from $600,000 to $1 million;
- Established Roth IRAs and increased the income limits for deductible IRAs;
- Established education IRAs;
- Conformed AMT depreciation lives to regular tax lives; and
- Phased in a 15 cent per pack increase in the cigarette tax.
to Treasury's original estimates, the 1997 tax cut was relatively
modest, amounting to just 0.11 percent of GDP in its first year and
0.22 percent of GDP by its fourth year. In 2007, the fourth-year effect
would be roughly equivalent to a reduction in the overall tax burden of
about $30 billion. Despite its modest size, tax cut advocates had high
expectations for the tax cut's effects on the economy because the
reduction in the capital gains tax rate was expected to unleash a
torrent of entrepreneurial and venture capital activity. They were not
In 1995, the first year for which this data is available, just over $8 billion in venture capital was invested.
Venture capital is especially critical to a vibrant economy because
high-risk/high-return investment permits promising new businesses to
blossom, rapidly spreading new technologies and new ideas into the
marketplace and across the economy. Such investments, when successful,
generate returns to investors that are subject primarily to the tax on
capital gains. By 1998, the first full year in which the lower capital
gains rates were in effect, venture capital activity reached almost $28
billion, more than a three-fold increase over 1995 levels, and by 1999
it had doubled yet again.
The explosion in venture capital
activity cannot be entirely credited to the cut in capital gains tax
rates, as the cut fortuitously coincided with technological
developments that gave rise to the internet-based "New Economy."
However, the rapid development and application of these new
technologies could not have occurred at such a rapid clip absent the
enormous investment flows made possible largely by the reduction in the
capital gains tax rate. This experience demonstrated yet again the
truth of the axiom: The less you tax of something--in this case,
venture capital investment--the more you get of it.
Comparing the Periods
Clinton years present two consecutive periods as experiments of the
effects of tax policy. The first period, from 1993 to 1996, began with
a significant tax increase as the economy was accelerating out of
recession. The second period, from 1997 to 2000, began with a modest
tax cut as the economy should have settled into a normal growth period.
The economy was decidedly stronger following the tax cut than it was
following the tax increase.
economy averaged 4.2 percent real growth per year from 1997 to 2000--a
full percentage point higher than during the expansion following the
1993 tax hike (illustrated in the graph above). Employment increased by
another 11.5 million jobs, which is roughly comparable to the job
growth in the preceding four-year period. Real wages, however, grew at
6.5 percent, much stronger than the 0.8 percent growth of the preceding
period (illustrated in the graph below). Finally, total market
capitalization of the S&P 500 rose an astounding 95 percent. The
period from 1997 to 2000 forms the memory of the booming 1990s, and it
followed the passage of tax relief originally opposed by President
summary, coming out of a recession into a period when the economy
should grow relatively rapidly, President Clinton signed a major tax
increase. The average growth rate over his first term was a solid 3.2
percent. In 1997, at a time when the expansion was well along and
economic growth should have slowed, Congress passed a modest net tax
cut. The economy grew by a full percentage point-per-year faster over
his second term than over his first term. The evidence is fairly clear:
The tax cuts, especially the reduction in the capital gains tax rate,
made a major contribution to a strong economy. Given this observation,
it seems likely, though admittedly less certain, that the tax increases
in 1993, while not derailing the economy as many had forecast at the
time, did indeed slow the recovery compared to what the economy could
of tax increases often reference the Clinton 1993 tax increase and the
subsequent period of economic growth as evidence that deficit reduction
through tax hikes is a pro-growth policy. What these proponents ignore,
however, is that the tax increases occurred at a time when the economy
was recovering from recession and strong growth was to be expected.
They also ignore that the real acceleration in the economy began in
1997, when economic growth should have cooled. This acceleration in
growth coincided with a powerful pro-growth tax cut.
evidence is persuasive that the tax increase probably slowed the
economy compared to the growth it would have achieved and that the
subsequent tax cuts of 1997, not the tax increases, were the source of
the acceleration in real growth in the latter half of the decade. As
taxes are now above their historical average as a share of the economy,
and are rising, Congress should look to enact additional tax relief to
keep the economy strong.
U.S. Department of Treasury, Office of Tax Analysis, "Revenue Effects of Major Tax Bills," September 2006.
Total non-farm payroll, payroll survey, Bureau of Labor Statistics.
Average hourly earnings, non-supervisory employees, Bureau of Labor Statistics.