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What Is “Pro-Growth” Tax Reform?

September 14th, 2011 . by economistmom

I testified before the House Budget Committee this morning, for a hearing entitled “The Case for Pro-Growth Tax Reform.”  My full written testimony is available at the committee’s website and also at the Concord Coalition site, here.  (Later you should be able to see the video on the committee website.)

As I explained at the opening of my testimony:

[T]he “case” for pro-growth tax reform is easy and non-controversial—as achieving a stronger economy makes pursuing any other social goals easier (deficit reduction, higher and fairer standards of living, greater investment in higher quality public goods and services, etc).

The disagreement is over what makes a given tax reform “pro-growth.”

Growing the economy through tax policy isn’t as simple as “cutting taxes” to reduce overall tax burdens.  Tax cuts all have benefits, but the first thing one learns in an economics class is in a world of scarce resources, we maximize well being by weighing costs against benefits, and at the margin starting from where we are right now.  Tax cuts that might benefit particular households and businesses don’t necessarily pass society’s cost-benefit test, even based on a narrower and naïve goal of maximizing GDP because:

(i)           If deficit financed, the direct reduction in public saving will typically outweigh any positive response from private saving, so national saving and economic growth falls.  This is the biggest factor preventing simple cuts in overall tax rates from being “pro growth” over the longer term.

(ii)          How taxes are cut matters:  marginal tax rates are what matters for supply-side growth effects (increases in incentives to work and save), and those responses depend on how large the change in marginal rates (we’re starting from relatively low rates), how large the responsiveness (“substitution effects”) of households and businesses to those rates (often pretty small), and how other factors (such as “income effects”) may swamp those responses to price changes.

(iii)          In an economy still recovering from recession, we have to worry about getting back to “full employment” (where we are putting all of our productive capacity to use) before turning to growing the productive capacity of the economy over the longer term.  Tax policies that help increase demand for goods and services (and hence businesses’ demand for workers) can be quite different from those that increase the supply of labor and capital.

Our experience with the Bush tax cuts has demonstrated each of these challenges, as their major contribution to record-high deficits clearly reduced national saving and economic growth, were not very effective at growing the supply side of the economy (even according to the Bush Administration’s own Treasury Department), and are not the kind of tax cuts that provide high “bang per buck” in a recessionary economy.

That is, growing the economy isn’t as easy as just “cutting taxes,” because the loss of revenues feeds dollar-for-dollar into a higher deficit and reduced public saving.  Unless private saving responds immediately or even eventually like gangbusters to the form of the tax cut (and that’s never been our experience by the way), national saving–the sum of public plus private saving–will likely fall.  So the first effect of a tax cut on economic growth is that direct and certain negative effect of the deficit on saving, that we gamble away for the hope of an uncertain positive private sector response to at least partially offset it.  But empirically, it never comes close to fully offsetting it, so empirically, there is always a cost to tax cuts that has to be weighed against any benefits.

It’s not enough that tax cuts are “good” (especially for those who receive them).  They have to be good enough.

9 Responses to “What Is “Pro-Growth” Tax Reform?”

  1. comment number 1 by: ST Dog

    ” the Bush tax cuts has demonstrated each of these challenges, as their major contribution to record-high deficits”

    ” the loss of revenues feeds dollar-for-dollar into a higher deficit”

    Couldn’t disagree more. And the whole mnd set of “paying” for reduced revenue is half the problem with the budget.

    Simply put, spending, actual outlays of funds from the treasury, is the only thing that causes deficits/debt. Spending should always be based on revenue. If revenue is reduced, regardless of cause, spending should be reduced. The failure to reduce spending is the source of deficits and debt.

    The only “cost” of a tax cut is the loss of power, influence, control the governemnt has on the people.

    If I change jobs for a lower pay (ie. revenue decrease) that does not cause me to go into debt. My unwillingness to reduce spending does.

    The country as a whole is suffereing because of the example set by the governemnt. Decades of debt piling up due to peole spending more than they make, and 6th goivernemnt encourages this. No saving to pay for something, just go into debt. No need to wait, get it now and pay later

    No savings. No buffer. Increased reliance on the governemnt. Increased governement control.

  2. comment number 2 by: Arne

    “It’s not enough that tax cuts are “good” (especially for those who receive them). They have to be good enough.”

    The flip side is that it is not enough that a spending program (e.g. infrastructure) is good. It needs to be good enough.

    With representative government the electorate does not need to learn what is really being done for us. Not that that stops the complaints after the fact.

  3. comment number 3 by: Arne

    “If revenue is reduced, regardless of cause, spending should be reduced.”

    I would agree as long as you include the stipulation that this should be done over the economic cycle. Right now I think the Tea Party has the nations focus on the number two problem - unemployment being number 1. When we have unemployment below 6 percent (actually when it will clearly get there), we should be making sure the increased revenue is balanced against the accumulated loss of revenue caused by the recession and does not go to growing government.

    I would also note that the corollary is that if there are no spending cuts, there should be no tax reductions. Exactly the problem with the 2001 and 2003 tax cuts and another reason to let them expire at all income levels.

  4. comment number 4 by: AMTbuff

    >national saving–the sum of public plus private saving

    The term public saving was unfamiliar to me, so I did a search. I learned that it refers to the excess of government revenue over government spending, aka annual surplus. Now I know why this term was so unfamiliar!

  5. comment number 5 by: Hoppe

    Mom…
    Tax cuts, as we come to know them are little more than congressional favors in exchange for votes, campaign contributions, etc…

    These cycles will continue so long as Congress has the authority to pick winners and losers through tax legislation.

    Businesses and families must be enabled and encouraged to save and invest based on a constant- such as a flat, untouchable tax system.

    While on the subject Ron Paul told me years ago in a cynical moment, that Congress will never adopt a tax system that cannot be fiddled with ( flat tax) because they give up the basis of their power and ability to raise contributions.

    This is all a side show.

  6. comment number 6 by: Ralph Musgrave

    Mom: What on earth is wrong with tax cuts leading to “higher deficits”? And please don’t tell me that deficits lead to more debt: as Keynes and Milton Friedman and numerous other economists pointed out, deficits can perfectly well accumulate as more monetary base rather than more debt. But the Washington DC elite have never read Keynes or Milton Friedman – or indeed any economics.

    And don’t tell me that more monetary base is inflationary. Obviously TOO BIG an increase would be inflationary. But get the increase just right and you get enough stimulus to raise employment with exacerbating inflation too much.

  7. comment number 7 by: Patrick R. Sullivan

    Shakespeare knew what pro-growth tax reform looked like over 400 years ago. Henry VIII, Act I, scene 2:

    http://www.shakespeare-literature.com/Henry_VIII/3.html

    The queen enters to announce to Henry that the peasants are in revolt over a new tax imposed by Wolsey of 1.6 of their ’substance’, the Duke of Norfolk chimes in with:

    ‘…upon these taxations,
    The clothiers all, not able to maintain
    The many to them longing, have put off
    The spinsters, carders, fullers, weavers, who,
    Unfit for other life, compell’d by hunger
    And lack of other means, in desperate manner
    Daring the event to the teeth, are all in uproar, ‘

    Henry asks Wolsey:

    ‘Taxation!
    Wherein? and what taxation? My lord cardinal,
    You that are blamed for it alike with us,
    Know you of this taxation? ‘

    When it turns out he does Henry orders it be revoked, because:

    ‘We must not rend our subjects from our laws,
    And stick them in our will. Sixth part of each?
    A trembling contribution! Why, we take
    From every tree lop, bark, and part o’ the timber;
    And, though we leave it with a root, thus hack’d,
    The air will drink the sap. To every county
    Where this is question’d send our letters, with
    Free pardon to each man that has denied
    The force of this commission: pray, look to’t;
    I put it to your care. ‘

    Arthur Laffer never said it so well.

  8. comment number 8 by: Vivian Darkbloom

    Good source. And, to think that the tax rate was just under 17 percent!

    The history behind this, as reported by Holinshed is that Henry wanted to wage war against France and to do that he needed to raise money. So, he put his administration to work to raise a tax.

    Specifically, according to Holinshed (G. Bullough Narrative and Dramatic Sources of Shakespeare, VOL IV, p. 464), the ultimate damage was with respect to employment:

    the “rich clothiers…went about to discharge and put from them their spinners, carders, fullers, weavers, and other artificers, which they kept in work afore time”.

    This is sometimes referred to as the Weaver’s Rebellion of 1525. There is no evidence Katherine had anything to do with it; rather the about face had more to do with the rebellion than the Laffer Curve. The first Tea Party? And, Shakespeare does seem to foreshadow Arthur Laffer, but with considerable more flair and wit.

  9. comment number 9 by: David Boone

    • The FairTax is simple. One rate for all new goods and services, period, end of infinite amendments stretching for tens of thousands of pages
    • The FairTax is noninvasive. With the single rate imposed at the point of sale, the government no longer has an interest in the amount or source of anyone’s income.
    • The FairTax is efficient. More than 80% of all tax returns are eliminated under the FairTax–every individual filing. What remains are retail outlets collecting the FairTax. Of these, 80 percent of all retail sales now occur at large retail chains
    • The FairTax is stable. Economists know consumption taxes in general are a more reliable source of revenue than systems based on income. David G. Tuerck, Beacon Hill Institute, calculates a revenue gain of 213 billion dollars if the FairTax had been in effect in 2010.
    • The FairTax is visible. The tax rate will be printed on every cash register receipt as a reminder of the cost of operating the federal government. How many of us can say how much federal income tax we pay now?
    • The FairTax is neutral (fair). Under the FairTax, Congress’s power to dole out favors for special interests would go away by eliminating the IRS and repealing the 16th Amendment.
    • The FairTax encourages economic growth. Research estimates that GDP would grow by 10% the first year and continue at approximately that rate for the foreseeable future. With its single rate, transparency and simplicity, business would know what to expect. The fact that business doesn’t know what to expect is the single greatest impediment to economic growth.
    • The FairTax is broad based. In fact it’s broader based than any alternative proposal including a flat tax or the current income tax.
    • The FairTax provides equality. Everyone pays the same rate at the time of purchase. Everyone receives reimbursement of tax paid on necessities based on poverty guidelines established by the federal government. In fact everyone receives that reimbursement each month, before they spend.
    • The FairTax would be constitutional. A consumption tax is much more in keeping with the intent of the founding fathers who railed against direct taxes and levies on property. Prior to the 16th Amendment, an income tax was always considered unconstitutional by the Supreme Court.