Fiscally-Responsible Tax Cuts: Not an Oxymoron, and Better for Economic Growth
May 11th, 2008 . by economistmomI am really tired of hearing the argument (or rhetoric) that a pro-growth fiscal agenda requires deficit-financed tax cuts, or tax cuts whose costs are not offset by revenue increases elsewhere, or spending cuts. There are two main reasons why deficit-increasing cuts in taxes (even of the “most efficient” kind such as reductions in marginal tax rates) are far less effective in promoting longer-run economic growth than are revenue-neutral changes in tax policy (e.g., a cut in marginal rates that is “paid for” with a broadening of the tax base).
First, if marginal tax rates are cut and the tax take (revenue collected) is reduced at the same time, there are offsetting effects on the economic activity of households. All economists believe in the positive “supply-side” or incentive effects of cuts in marginal tax rates, which by increasing the reward to working and saving, should encourage working and saving. Now, the label “supply-side” is often misinterpreted as equivalent to “Laffer Curve” philosophy, which says that cuts in income tax rates will encourage working and saving so much that the increased taxable activity more than makes up for the lower rate, causing revenues to actually rise when tax rates fall. Empirically (i.e., in the real world), the U.S. is nowhere near the level of marginal tax rates (maybe 70-80 percent) where the Laffer Curve phenomenon might apply. (I will write further on the Laffer Curve in future posts.) In fact, what makes it difficult to produce such large changes in economic behavior from small changes in marginal tax rates is that, to put it in economist terms, non-revenue-neutral changes in tax rates involve “income effects” as well as “incentive” or “substitution effects.” To put this in “mom” terms, if the marginal tax rate I face on my labor income is reduced, say, from 33 to 30 percent, there are two distinct effects on my decision about how much I want to work: (i) with the reward to working each additional hour now higher (because a smaller percentage is taken in taxes), I am encouraged to work more hours; but on the other hand (ii) with a higher return on the hours I already work, that means I could work fewer hours and net the same amount of income, so I might in fact choose to work less. Ditto for the effect on my savings behavior when a cut in marginal tax rates raises my after-tax interest income–I might be encouraged to save more in response to the higher net return, but on the other hand, I could afford to save less.
If instead, the tax rate cut was financed in a revenue-neutral (or deficit-neutral) manner that effectively removes the “income effect” on individual household behavior (at least for the average household), then the tax cut produces the positive incentive effect only, and thus more certainly leads to an increase in the labor supply or saving of households. (For example, if my marginal tax rate is reduced but at the same time my mortgage interest deduction is reduced, I am more likely to increase my saving and work than if my mortgage interest deduction had not been reduced.)
Second, if tax cuts lead to higher deficits, then public saving is directly reduced, and unless private saving is encouraged enough to more than offset, will lead to declines in national saving and economic growth. The first point above already makes it hard for private saving to increase in response to a deficit-financed tax cut, to the extent that the income effects operate. Historical experience over the past few decades has demonstrated that national saving tends to move with, not in opposition to, public saving. When deficits turned to surpluses in the late 1990s, national saving rose substantially, and so did economic growth. When surpluses turned back into record deficits after 2001, national saving plummeted. (Much more on this in future posts. I think fondly of the late Ned Gramlich and how much he helped me on this issue in various contexts.)
It’s not that I don’t believe in the supply-side effects of tax cuts operating on the private sector–I do. It’s just that empirically (in the real world) we never see responses large enough to make the case for deficit-financed tax cuts as the best kind of tax cuts to encourage economic growth. I used to be considered a “supply-side economist” who modeled the incentive effects of taxes in a dynamic, general-equilibrium model with all the bells and whistles that reflected all the largest levers that are pulled when tax rates are changed. But over the years as I experienced more observations of the real world, those bells and whistles got quieter and quieter as the levers seemed to shrink. (Among my economist friends, I always say “my elasticities declined” as I grew older.)
This reasoning implies that revenue-neutral (not revenue-losing) tax reform, is the way to conduct tax policy to encourage national saving and economic growth. In fact, if we could get really serious about tax reform and broaden the tax base in an efficient way, then revenue-gaining tax reform, which would raise revenue (and public saving) without increasing the tax rates on productive economic behavior, would be even better for the economy. (More on this idea in future posts as well.)
Ah, economic policy! Just to add to the pot…There are TWO reasons for taxes - generation of revenue for governmental purposes, and redistribution of income/wealth. We have really drifted away from the second purpose, and in doing so, made the rich richer and the poor poorer. The bottom line, for the United States, is that we do need a middle class as customers for consumer goods et al. The very rich just sock a bunch of that money away. So, I call for a meaningful return of estate tax. There is no better taxpayer than a dead taxpayer. The redistribution allows us to make the life of more of the citizens bearable. Think health care, for example.
So, bring back estate taxes!
Linda
I am really tired of hearing the argument (or rhetoric) that a pro-growth fiscal agenda requires deficit-financed tax cuts.
I agree that deficit-financed tax cuts are the height of fiscal irresponsibility. If we can’t convince the electorate to accept spending cuts or revenue increases elsewhere at the moment that they receive the tax cuts, how can be expect to convince them later? The answer, of course, is that we can’t.
Regarding the Laffer Curve and the claim that tax cuts pay for themselves, I went and looked at the numbers myself several years ago. After all of the bragging that I’d heard from supply-siders, I really expected to find something. Instead, the numbers were pretty much what one would expect. When taxes are cut, revenues go through a quick drop and then continue to grow with the GDP as before, just at their new lower level. Hence, tax cuts are not a free lunch. They require us the weigh their benefits versus their costs, just like most things in the real world.
I’ve posted the results of my study of the numbers at http://home.att.net/~rdavis2/taxcuts.html . For years, I’ve asked supply-siders to tell me any specific numbers or conclusions in my analysis that they disagree with. Alternately, I’ve asked them to post a link to one serious economic study that purports to show evidence of any income tax cut that has ever paid for itself. I am yet to get a serious response. Anyhow, thanks for your excellent blog. Am glad I ran across it and have already bookmarked it.
Some questions:
Tax cuts occurred in the 1980’s, 1960’s and the 1920’s after which the economy exhibited hugh growth. Higher taxes in the 30’s and the 70’s were a contributing factor to a depression and stagflationary environment. Yes, the 90’s had high growth but taxes were still low when compared to other eras and the real growth didn’t occur until a capital gains cut and a Congress make up that guranteed gridlock on spending. Also, if I remember correctly, if expenditures just stayed at the rate of inflation, the additional revenues of a growing economy would have eliminated a deficit.
So why should I want to raise taxes or follow some revenue neutral formula?
Tax cuts occurred in the 1980’s, 1960’s and the 1920’s after which the economy exhibited hugh growth.
I haven’t looked at the 1920’s but if you look at the first graph at http://home.att.net/~rdavis2/taxcuts.html , you’ll see that 10-year GDP growth (the purple line) has been fairly stable since the 1965 to 1975 span. The 10-year span happens to come close to matching the length of the business cycle since then. We had recessions in 69-70, 80-82, 90-91, and 2001 (with an additional one in 74-75).
Higher taxes in the 30’s and the 70’s were a contributing factor to a depression and stagflationary environment.
I haven’t looked at the 30’s but taxes were NOT higher in the 70’s. If you look at page 17 in the Treasury document at http://www.ustreas.gov/offices/tax-policy/library/ota81.pdf , you’ll see that there were 5 major tax bills and they were all estimated to cut revenues. Also, the top marginal rate did not change during the 70’s. If you have evidence that taxes were higher during the 70’s, please present it.
Yes, the 90’s had high growth but taxes were still low when compared to other eras and the real growth didn’t occur until a capital gains cut and a Congress make up that guranteed gridlock on spending.
If you look at the first graph at http://home.att.net/~rdavis2/gdpchg07.html , you’ll see that GDP growth was relatively high from 1992 to 1999, well before the capital gains tax cut in 1997. The highest level was from about 1996 to 1999 but GDP growth fell rapidly after that so, if the capital gains tax cut provided any benefit to GDP, it was a very short one.
Also, if I remember correctly, if expenditures just stayed at the rate of inflation, the additional revenues of a growing economy would have eliminated a deficit.
Most expenditures need to grow at the rate of inflation PLUS the rate of population growth to remain the same per capita. That’s why it’s more reasonable to try to keep spending and revenues at a stable percentage of GDP. Of course, even this will be difficult in the future as the workers per retiree ratio decreases (as mentioned by Diane in her Basic Math post of May 12th).
So, as I asked in comment number 2 above, please tell me any specific numbers or conclusions in my analysis at the URL that I give. Alternately, please post a link to one serious economic study that purports to show evidence of any income tax cut that has ever paid for itself. I am open to any real evidence. But until someone shows me that evidence, I’ll just have to stick with the numbers and every economic study that I’ve read on the subject.