Sunday, July 13, 2008

Can Tax Cuts Lower Economic Growth?

Free Exchange claims tax cuts raise income growth:

Mr Drum also appears to easily reject supply-side economics. There seems to be a temptation lately to label anyone who even dares mention supply-side economics, without immediately deeming it the silliest idea born to a napkin, an economic heretic. That's unfortunate. True, with the exception of very high marginal tax rates, a tax cut will generally not pay for itself. But there exists ample empirical evidence that cutting income taxes does increase growth. Thus, the long-run impact of a permanent tax cut is still up for debate. The effect of lower-income tax rates on labour supply is mixed. But it does seem, at the very least, lower tax rates decrease the amount of tax evasion. Writing off supply-side economics as a blatant fallacy is as much of a 1990s relic as wearing a goatee.

Exuberant Rationality has one objection:

it seems wrong-headed to keep taxes this low when government debt is ridiculously high and growing faster than ever, our infrastructure is in dire need of maintenance, and fee-based services (such as publicly-provided higher education) are becoming more expensive.

Let me suggest another. The claim that tax cuts lead to more output via incentive effects presumes that we are talking about fiscally neutral reductions in taxes and government spending. What we got from the Reagan and Bush 43 administrations – and what is proposed by McCain – is a reduction in taxes that is much larger than any proposed reduction in government spending (government spending as a share of GDP actually rose under Bush43). The impact of this fiscal stimulus was a reduction in the national savings rate, which lowers long-term growth.

As Exuberant Rationality notes, fiscal restraint might entails less public investment in infrastructure and education. As a pro-growth liberal, I’m in favor of more public investment in infrastructure and education as less investment likely would hurt long-term growth.

8 comments: said...


It may be worth noting that this outcome of both the Reagan and Bush II tax cuts goes against theory that has been entrenched in textbooks even to the upper level undergrad level, namely rational expectations, which supposedly implies Ricardian equivalence: tax cuts should lead to a higher savings rate.

The disconnect is even greater when we realize that both of those tax cuts were tilted to the rich who supposedly save more than the poor, but the savings rate fell anyway. Of course those who are proud to call themselves supply-siders somehow never consider that the nature of government spending is important in the equation eithre: it is all presumed to be wasteful unless it is for the military, in which case it is merely necessary. Infrastructure spending is "pork barrel" and education spending is "paying off teachers' unions."

This sort of mentality filters down to the state level as well. So, northern Virginia has the second worst traffic jams in the US. But a special session of the legislature failed to agree on a plan to deal with it because it would involve tax increases. It was the Republican-run Assembly that blocked the governor and the Senate on all proposals. There is now talk of businesses not wishing to locate in northern VA because of the traffic situation.


Bruce Webb said...

"Abundant empirical evidence"

Which somehow doesn't show up in official government data series. BLS: Productivity Eighteen months after the Bush 2003 tax cuts, which is where 'economists' like Phil Gramm tell us the impact of tax increases or tax cuts become visible in the larger economy, productivity numbers fell of the cliff and have pretty much stayed there ever since.

Now correlation is not causation, on the other hand correlation is kind of at the core of empiricism, and non correlation even more so. The economy is too complicated and too burdened by time lag effects to simply apply Popperian notions of falsification, but it is really, really hard to stretch this data series into "abundant empirical evidence" of tax cuts leading to investments leading to producitivty increases down the road. Because it just didn't happen. At least according to those madcaps at the BLS.

Anonymous said...

Economy will be complicated when we didn't plan on it properly on various basis especially on finance basis.

ProGrowthLiberal said...

"Ricardian equivalence: tax cuts should lead to a higher savings rate."

Ricardian Equivalence implies that the PRIVATE savings rate rises to offset the rise in the government deficit to income ratio so the national savings rate does not change. But you are right about the empirical evidence - during the 1980's and over the past few years, we did not see this offsetting rise in the private savings rate aka we shall declines in the national savings rate.

Shag from Brookline said...

In my legal career of the past 50+ years, I recall 70% tax rates (and over 90% in my pre-law youth). While I never did get to the income levels for the 70% federal income tax rate, I did dwell in the 50% rate. In my experience high tax rates served as a disincentive ONLY if I had to work exta hard for additional income that might get me into an oppressive bracket. But since not that much heavy lifting is involved in the ethical practice of law, I did not hesitate to increase my income as the net amount (of both federal and state taxes) was useful, e.g. saving for children's college tuitions so that they (or I) would not have to go into debt. Many persons claiming disincentives of high tax rates most likely did not have to do that much heavy lifting for additional income; their real gripe was that they hated paying taxes. said...

From about 1940 until 1964 or so, the highest marginal income tax rates were over 90%, and the economy did pretty well by and large during that period. It is true, however, that the various tax cuts on that top rate did increase revenues from the top income group. A lot of loopholing and exempting went on in those days (oil depletion allowances and all kinds of wonderful toys).

Unknown said...

If you hear the sound of hooves and you are standing in Wyoming, think horses, not zebras. All economic theories that question whether tax rates affect growth are placing zebras in Wyoming.

Competently run businesses (and that includes most privately held firms of any size) consider an investment based on expected after-tax returns. As a tax lawyer for 25 years, I have watched my clients shift, reshift and shift again their resources between hard assets, operating businesses, stocks and bonds as expected after-tax rates of return shift in relative terms. Unless someone can show that what I observed, and earned a good living facilitating, on a daily basis for the last quarter of a century was exceptional, I can assure every economist in the country that changes in tax rates cause immediate and substantial changes in the allocation of capital independent of changes in government spending. In short, tax rates constitute a huge, sensitive, ever-present dynamic. In this regard, I am assuming that some categories of investments lead to more growth than others

Anonymous said...

Can anyone help explain how tax cuts–especially those for the highest tax brackets–result in economic growth? Aren’t the wealthy just sitting on their profits–or spending it to outsource their jobs? And if so, how did the economy grow during the Reagan era. Was it a fluke? Or is there another way to see it?