Can Tax Cuts Pay for Themselves?
By SIMON JOHNSON
Can tax cuts “pay for themselves,” inducing so much additional economic growth that government revenue actually increases, rather than decreases? The evidence clearly says no.
Today’s Economist
Perspectives from expert contributors.
Economists disagree about almost everything, of course, and the effect of tax cuts is no exception. One reasonable way to assess the evidence is to begin with the highest plausible effects, then see what happens if some of the more extreme assumptions are relaxed (this is a nice way of saying that we don’t believe everything the authors are trying to tell us).
I would start with a study by Gregory Mankiw, former chairman of George W. Bush’s Council of Economic Advisers – and therefore presumably on the tax-cutting side of American politics – and Matthew Weinzierl (published in The Journal of Public Economics in 2006 and, unfortunately, available only to subscribers) that shows the economic growth caused by a tax cut can offset, at best, a portion of the revenues lost by that tax cut.
Specifically, Professors. Mankiw and Weinzierl calculated that 32.4 percent of the “static” or direct revenue loss of a capital-gains tax cut and 14.7 percent of the static revenue loss of a labor tax cut could be offset in present-value terms by additional growth, ignoring short-term Keynesian effects (i.e., any immediate stimulus provided to the economy).
Now 32.4 percent is a lot, but it is far less than 100 percent. And a critical assumption for Professors Mankiw and Weinzierl is that government spending falls to keep the budget in balance. In their framework that’s a good thing — as they are effectively assuming away the consequences of any productive effects of government spending (e.g., what if less spending on schools means less education and this hurts “human capital” and therefore productivity down the road?).
Sticking for a moment with just with their view of the world, if instead the tax cuts are financed by additional debt, as was our collective experience during the 2000s, the ultimate effect of those cuts can be to lower economic growth in the long term, depending on whether the larger debt eventually leads to lower government transfers, lower government consumption, higher taxes on capital or higher taxes on labor. (Eric M. Leeper and Shu-Chun Susan Yang discuss this in “Dynamic Scoring: Alternative Financing Schemes,” also in The Journal of Public Economics, in 2008.)
More broadly, in 2005, the Congressional Budget Office, then headed by a Republican appointee, Douglas Holtz-Eakin, estimated that the economic effects of a 10 percent cut in income taxes would offset from 1 to 22 percent of the revenue loss in the first five years; in the following five years, the economic effects might offset up to 32 percent of the revenue loss, but might also add 5 percent to the revenue loss.
This is an entirely reasonable assessment — the budget office exists to provide balanced analysis for the budget process. The bottom line is that betting that tax cuts will pay for themselves is a high-risk strategy and not a good idea at our current levels of government debt relative to gross domestic product. We do not have a large margin for error. (Disclosure: I’m on the Panel of Economic Advisers for the the budget office, but I didn’t have anything to do with that study.)
Of course, economic studies do not necessarily have a direct effect on political discourse. For example, President George W. Bush asserted in 2007, “It is also a fact that our tax cuts have fueled robust economic growth and record revenues.” But this is nothing more than an assertion. Growth during the 2001-7 expansion was only 2.7 percent compared, for example, with 3.7 percent during the 1990s expansion (when tax rates were higher).
And much of the growth during the Bush period turned out to be illusory; it was based on our corporate and national accounting system, which measures profits (an important part of G.D.P.) but not on a risk-adjusted basis. When the risks materialized in the financial crisis of 2008-9, we lost so much output that G.D.P. per capita in real terms today is only at about the level of 2005.
To assess growth properly, you should look “over the cycle,” meaning roughly 10 years for the modern American economy. It is hard to argue that the last decade was any kind of growth success. Of course, other things happened during the 2000s, including further financial sector deregulation not directly related to the tax cuts.
That’s why we have the economic analysis, particularly by the budget office, to disentangle what tax cuts can really do. If the supercommittee buys into dynamic scoring for tax cuts, at best this would be wishful thinking. At worst, it would represent yet another round of fiscal irresponsibility at the top of American politics.
And if people are seriously considering altering the rules under which the the budget office operates, they should stop and think again. Changing the score-keeping guidelines at this stage would amount to undermining the credibility of the office, one of the few remaining impartial and well-informed observers of the nation’s economy.
Perhaps this strategy might yield some short-term political gains, but the damage to our creditworthiness would be immense, and the consequences would be felt sooner rather than later.
The nightmare downward spiral and fiscal implosion in the euro zone began with a few countries cheating on their numbers — first to get into the currency union and then to avoid various forms of official criticism. We do not want to start down the same path.
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