…because I’m an economist and a mom–that’s why!

We Can’t Entitle Our Way Out of Paying Taxes

August 23rd, 2008 . by economistmom

Thursday’s Wall Street Journal contained an opinion column by Glenn Hubbard, arguing that ”We Can’t Tax Our Way Out of the Entitlement Crisis.”  Glenn, whom I worked closely with as his resident tax-policy antagonist at the Council of Economic Advisers for the first 100 days of the Bush Admininstration (my being a staff holdover from the Clinton Administration CEA), uses the column to criticize what seems to be Senator Obama’s tax-heavy approach to entitlement reform (or at least Social Security reform). 

Glenn argues that with combined spending on Social Security, Medicare, and Medicaid projected to rise by nearly 10 percentage points of GDP over the next 40 years (he cites CBO numbers for this), relying on revenues alone to keep deficits from expanding would require revenues to increase by 10% of GDP.  With revenues/GDP currently around 19%, a boost of 10% of GDP would take us to 29%–which is the “simple arithmetic” Glenn refers to here:

…Social Security and Medicare spending left unchecked would, after a generation, consume about 10 percentage points more of GDP than it does today.

Simple arithmetic suggests that with this much more of GDP eaten up by the two programs, all federal taxes on average would have to be raised by more than 50% to make up the shortfall…

But enough of my “fact checking.”  I don’t work for Glenn anymore.  Glenn goes on to point to some academic research that demonstrates the danger of Obama’s taxes-only approach (emphasis added):

Research by economists Eric Engen of the Federal Reserve Board and Jonathan Skinner of Dartmouth suggests that such a tax increase would reduce long-term GDP growth by about a full percentage point. This is no small matter: Think of it as reversing all of the gains in our long-term growth rate from the productivity boom of the past 15 years. 

Coincidentally, I know Eric Engen and Jon Skinner pretty well, too.  Eric and I were the only students in Jon Skinner’s Ph.D. public finance class at U. of Virginia back in the mid-1980s.  And I know something about this research that Glenn cites, the first thing being that this was a paper written 12 years ago, before we even saw the evidence (data points!) from the later years of the Clinton Administration that growth in revenues as a share of the economy could coexist with–and even encourage–strong growth in the economy overall.  The second thing I know about this paper (and you can see for yourself here) is that the “full percentage point” drop in GDP growth Glenn cites is derived from an Engen and Skinner conclusion about the effect of marginal tax rate changes, roughly translated into a “corresponding” range of average tax rate changes.  From the National Bureau of Economic Research summary of the paper (again, my emphasis added):

Engen and Skinner take two different approaches to discerning how taxes affect growth. First, they look at cross-country experiences. …A number of [cross-country] studies…have found that cutting marginal tax rates increases economic growth. Based on these cross-country studies, Engen and Skinner conclude that cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.

Second, Engen and Skinner turn to others’ research on the effect that changes in tax rates have had on the capital stock, labor supply, and R and D in the United States. They use the results of these studies to estimate the likely effect of cuts in tax rates. A hypothetical 5-percentage point cut in marginal tax rates, they conclude, would cause long-run economic growth to increase by 0.2 percentage points.

Both sets of studies suggest about the same answer: a 0.2 to 0.3 percentage point increase in growth rates in response to a major change in the tax structure, defined here as a decline in the average tax burden of 2.5 percent of GDP or a 5 percentage point marginal tax cut (for example, from a 15 percent marginal tax rate to a 10 percent marginal tax rate).

You see, the way economists view the importance of tax rates on economic growth is that it’s the marginal tax rate (the tax rate on the next, or marginal, dollar of income) that matters for economic incentives–the supply-side behaviors of labor supply and saving, which are what combined produce national output.  When we study the beneficial economic effects of what we think of as “tax reform,” the mental exercise is usually the following:  how would economic efficiency improve if marginal tax rates could be reduced (through base broadening), holding revenues (and hence average tax rates) constant?  Hence, the studies that Eric and Jon used in their 1996 paper to glean a relationship between tax rates and economic growth, were all largely based on the premise that the relationship that matters is between marginal tax rates and economic growth, not average tax rates and economic growth.  In fact, many of the studies Eric and Jon cite in their paper explicitly hold constant the average tax rate, the national saving rate, or the capital stock.  Why?  Because the studies try to isolate the incentive (or substitution) effects of tax policy.  But Eric and Jon made the mistake of providing the reader (to be helpful?) with a loose translation of what a given marginal tax rate change would imply for the average tax rate (in “real life” that is, where we tend to shun revenue neutrality), and then suggesting (unintentionally?) that their results based on the marginal tax rate, revenue-neutral changes, and economic growth, could translate directly into a connection between the average tax rate and economic growth.   Nope–you can’t do that.  (I thought Jon Skinner had taught both me and Eric that.)

And if you check out the paper, you’ll see that even with the connection between marginal tax rates and economic growth that Eric and Jon were really trying to emphasize, Eric and Jon weren’t exactly confident in the statistical ”robustness” of their empirical conclusions–from either the cross-country studies or their “sectoral, bottom-up” simulation approach.  They were very upfront about that, but that sort of language doesn’t get put into the NBER digest summary of a paper that has such a clean and precise conclusion and potential policy implication. 

So then Glenn comes along, 12 years later, with the claim that an Obama Administration is proposing to increase taxes by enough to fully cover the growth in entitlement spending over the next forty years, which implies that more than 50% increase figure, and a boost in the average tax rate from 19% of GDP to 29% of GDP.  That 10% of GDP increase in the average tax rate happens to be four times the 2.5% of GDP change in the average tax rate said by Eric and Jon’s 1996 paper to imply a corresponding 0.2 to 0.3 percentage point change in the GDP growth rate.  Hence, Glenn says the Obama “tax plan” would reduce GDP growth by four times 0.25 (0.2 to 0.3) percentage points, or voila –”a full percentage point.”  (Whoops, I said I was done with the fact checking, didn’t I?…)

So, get to my point?…  Besides the fact that Senator Obama has far from proposed to raise federal revenues as a share of GDP to 29% (he’s barely budging it from the 40-year historical average of just over 18% from what we’ve seen so far), even if anyone were to recommend such an increase in taxes, it would be an increase in the average tax rate we’d be talking about, not the marginal tax rate.  And for any given average tax rate, there are many different marginal tax rates, and schedules and patterns of marginal tax rates, that could correspond to that average rate.  Ideally, if deficits are deemed too large for the health of the economy, we do want to raise revenues/GDP (the average tax rate) and reduce spending/GDP, and we want to do that in a thoughtful way that weighs costs against benefits (i.e., maximizes the net benefit to our economy and our society).  Doing more on the tax side makes more sense if we can find ways to raise the average tax rate without raising marginal tax rates (or without raising too many marginal tax rates or the ones that people are most sensitive to).  That is, if we can combine our goals for deficit reduction with our goals for tax reform, raising the average tax rate doesn’t have to involve trading off economic growth.  In fact, raising the average tax rate without raising marginal tax rates is likely to boost national saving (as public saving would rise without adverse offsetting effects on private saving) and hence boost economic growth. 

But how is it possible to raise revenues as a share of GDP (the economy-wide average tax rate) without raising marginal tax rates?  Start by realizing our current income tax system applies to far from a “comprehensive” tax base (i.e., far from all of GDP).  If we could broaden the tax base, we could raise revenues without raising marginal rates.  Then it’s certainly possible to think about reducing the deficit through better tax policy; you don’t necessarily have to turn to “bigger” tax policy in terms of marginal tax rates.

Glenn Hubbard knows a lot about tax reform, and I know he believes in it.  That’s why I’m disappointed that he would forget about tax reform when it comes to how he thinks we ought to balance the budget.  Glenn says (my emphasis added):

Balancing the federal budget without a tax increase is possible, but will require strong fiscal restraint. To achieve full-employment budget balance by the end of the next president’s term in office, federal nondefense spending growth needs to be restrained to [a nominal] 2% per year instead of the currently projected 4.5%. And modest defense spending increases to fund costs of needed improvements in national security are possible.

We can also secure a firm financial footing for Social Security (and Medicare) without choking off economic growth or curtailing our flexibility to pursue other spending priorities. Three actions are essential: (1) reduce entitlement spending growth through some form of means testing; (2) eliminate all nonessential spending in the rest of the budget; and (3) adopt policies that promote economic growth. This 180-degree difference from Mr. Obama’s fiscal plan forms the basis of Sen. McCain’s priorities for spending, taxes and health care.

Glenn forgets what I know he knows:  there’s a lot of “entitlement spending” on the tax side of the budget, commonly referred to as “tax expenditures,” but what we at Concord view and refer to as “tax entitlements.”  I could easily edit Glenn’s three essential actions to apply to the tax side of the budget:

  • Three actions are essential: (1) reduce tax entitlements growth through some form of means testing (and better scruntiny of tax expenditures); (2) eliminate all nonessential (and often counterproductive) tax expenditures in the rest of the budget; and (3) adopt fiscally-responsible policies that promote national saving and economic growth.

Glenn should recognize that without these three actions tacked onto his list of essential actions on the spending side, there’s no guarantee that we can “tax cut” our way to a strong economy.

7 Responses to “We Can’t Entitle Our Way Out of Paying Taxes”

  1. comment number 1 by: Tim Ramsey

    I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog.

    Tim Ramsey

  2. comment number 2 by: Patrick R. Sullivan

    So, you’re endorsing Dick Armey’s Flat Tax?

  3. comment number 3 by: economistmom

    Patrick: Uh, no. Dick Armey’s flat tax was too regressive a change (exemption level provided some progressivity in the system overall but MUCH less progressivity compared with the current income tax system because of the single marginal tax rate), AND it was also fiscally irresponsible (he specified a marginal tax rate that was too low to be revenue neutral, even with his broader base). There are ways of making the tax base broader and reducing tax expenditures that would: (i) preserve or enhance the progressivity of the system, (ii) allow marginal tax rates (especially those with significant empirical effects) to stay low, hence improving economic efficiency and encouraging economic activity, AND (iii) on net raise revenue (reduce the deficit). That’s the kind of tax reform I’d support.

  4. comment number 4 by: Patrick R. Sullivan

    Only in academic papers does it work the way you’re describing. In the world as it is, a ‘progressive’ structure automatically gives incentives to lobby for tax expenditures.

    You can’t eat your cake and have it too.

  5. comment number 5 by: Brian Smith

    I have enjoyed your blog even though I admit, it is perhaps well beyond my grasp. Would you please consider the question of a simpleton?

    Everyone says that when marginal tax rates are decreased, tax revenue increases. O.K. That is all well in good, but, what happens to the savings rate?

    I suppose this would be very easy to get this data I just don’t know where to look. When I googled it I found articles from the likes of the CATO institute discussing the twenties (rather odd I thought). I would guess that when the rich do well they spend. The poor spend too, but save less. This creates more income, and therefore revenue until the credit stops and we start all over again. Is this too simplistic?

    I would guess that the idea that decreasing the tax rate to increase revenue by stimulating growth is analogous to sitting in my car at idle to get better fuel economy and save money. At some point there is a point of diminishing returns. My trip computer is showing 75 mpg, but I am not really going anywhere. Perhaps the CATO institute can do an analysis of the best way to save on fuel?

  6. comment number 6 by: economistmom

    Brian: well, actually, no–when we decrease marginal tax rates, the level of whatever economic activity we’re taxing MIGHT go up (even that depends on the incentive, or substitution effects, vs. the “income effects”), but revenues (tax rate times activity) typically goes DOWN (because the tax rate is decreased more than the activity is increased). The claim about decreased tax rates leading to increased revenues is known as the “Laffer Curve” effect–an effect only theorized to exist at extremely high marginal tax rates (maybe 75%+), which we are FAR from. Any other empirical observations that seem like Laffer effects are typically timing shifts–such as when you decrease taxes on capital gains, and induce an immediate realization of gains that would have otherwise been postponed. (Higher revenue initially only gets offset by lower revenue later, so there’s really no real Laffer effect.)

    It’s because revenue decreases when tax rates decrease that it’s not true that cutting marginal rates is an automatic positive for economic growth. If a tax cut leads to lower revenue and a larger budget deficit (i.e., if spending isn’t constrained as a result of the lower revenue), then the tax cut reduces public saving (makes it more negative). If private saving does not make up the difference in response to the cut in taxes, then national saving (the sum of public + private) will fall. If national saving falls, this is harmful to economic growth. This relationship was explained–in the opposite direction, explaining why tax rate increases can be good for economic growth–in President Clinton’s last (2001) Economic Report of the President (in a chapter I wrote).

    I have talked often on this blog about why “there’s no such thing as a free tax cut”–starting with my premiere post, so there’s too much to link to, but please browse the site, search for “taxes” or “revenue” using the search engine, and hopefully you will find more of what you may be looking for in terms of accessible explanations of what tax policy has to do with the budget deficit and economic growth. Thanks for reading!

  7. comment number 7 by: B Davis

    Brian Smith wrote:

    Everyone says that when marginal tax rates are decreased, tax revenue increases. O.K. That is all well in good, but, what happens to the savings rate?

    As economistmom said, the “everyone” of whom you speak have it exactly backwards (she actually said it much more elegantly, of course). I never cease to be amazed at how many people continue to push this theory. When I first heard about the touted rise in revenues after the Reagan tax cut, I went and looked at the numbers myself. 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 this link. 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. None have.

    The next time that someone tells you that theory, you might likewise ask them for a link to one study that provides evidence. Judging from my experience, you will get very few, if any, responses. If you should get any that seem serious, however, feel free to post the link as a comment at this link and I’ll take a look at it.

    Regarding, economistmom’s mention of the incentive and substitution effects, I read the following interesting description of them on page 116 of the book “The Coming Generational Storm”, co-written by economist Laurence Kotlikoff:

    …For tax cuts to raise revenues, pretax labor earnings have to rise by a larger percentage than the tax rate falls.

    There are two competing forces at play in determining whether pretax earning rise, stay the same, or fall. On the one hand, workers may say to themselves, “Boy, now that taxes are lower, I can work less and still receive the same after tax pay. I’m going to cut back my workweek.” On the other hand, they may say, “Boy, now’s a good time to work more and earn more because taxes are lower on every extra dollar I earn”. Economists call the first of these reactions the income effect. They call the second reaction, the substitution or incentive effect.

    Some of the best labor economists in the country have spent their lifetimes measuring the income and substitution effects. The broad consensus of these experts is that the two effects are roughly offsetting. This means that if wage tax rates are cut by, say 15 percent, tax revenues will fall by 15 percent.