Can Tax Cuts Lower Economic Growth?

Jonathan Chait has some fun with uber-supply-sider Lawrence Kudlow which we will come back to. But first – let me offer a complaint about the latest from Greg Mankiw. It is true that Mankiw called Dynamic Scoring a can of worms which is an incredible admission for someone on Team Republican. But in many ways, this does not go far enough:

Indeed, having an economic impact is a big part of why policy makers use the tools at their disposal, whether it is the tax cuts of Ronald Reagan and George W. Bush or the stimulus package of Mr. Obama … accurate dynamic scoring requires more information than congressional proposals typically provide. For example, if a member of Congress proposes a tax cut, a key issue in estimating its effect is how future Congresses will respond to the reduced revenue.

President Obama proposed fiscal stimulus when he first entered office because we were in a very deep recession with interest rates near zero, which is an incredibly different situation from where we were in 1981. It is well established that the Volcker FED was going to dictate the path of real GDP with his zeal to conquer inflation so all the Reagan tax cuts accomplished was to dramatically increase real interest rates lowering investment demand and hence long-term economic growth. Mankiw in fact noted this in one of the early editions of his macroeconomic text book but I guess drinking from the Bush43 Kool Aid has tempered his writings over the past 14 years. Which brings me to what Chait wrote about Kudlow:

He has argued continuously, since Bill Clinton raised taxes on the rich in 1993, that higher taxes on the rich must necessarily destroy economic growth, and that lower taxes on the rich must necessarily bring prosperity. As (perhaps owing largely to unfortunate coincidence) the exact opposite has happened instead, he has resorted to a series of frantic post-hoc revisions … Also, Kudlow “says Bush’s temporary and targeted 2001 and 2008 tax cuts failed, but that his big rate cuts in 2003 spurred a five-year ‘boom.’” So, to sum up, Bush’s supply-side tax cuts worked. But he also passed non-supply-side tax cuts (in 2001) that failed, and he spent too much.

Read the rest of Chait’s more accurate account of fiscal policy and the Bush economy. I will only note that there were almost as many conflicting explanations for the 2001 tax cut as there were for the invasion of Iraq. Greg Mankiw at the time argued we needed tax cuts to stimulate consumption and hence aggregate demand. Glenn Hubbard on the other hand was arguing that we needed tax cuts to encourage more savings. Of course these two rationales are mutual contradictions. My whole problem with Dynamic Scoring is that it may have the sign wrong. If we are in a situation where monetary policy can get us back to full employment, a tax cut that encourages consumption will lower national savings if it is not paid for by reductions in government purchases. As such, real interest rates rise lowering investment. Let me close by giving credit in two places starting with an interesting paper on real interest rates over history by James Hamilton et al,:

although it is often assumed in theoretical models that there is some long-run constant value toward which the real interest rate eventually returns, our long-run data lead us to reject that hypothesis

Note in particular the high real interest rates during the 1980’s which should cause anyone to question the supply-side claim that the Reagan tax cuts promoted growth. But let’s also give credit to John Oliver for noting the need for government infrastructure investment even if that requires a rise in gasoline taxes. Odd that an English comedian understands fiscal policy better than someone like Kudlow but then some claim that Kudlow is nothing more than a clown.