I 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.)
