Deficits and Tax Cuts

October 17, 2006

This morning’s Washington Post had an interesting article titled “Lower Deficit Sparks Debate Over Tax Cuts’ Role,” highlighting the issue that has hovered over political economy debates for the past two decades – how much of a tax cut pays for itself? From the Washington Post:

With great fanfare, President Bush last week claimed credit for a striking reversal of fortune: New figures show the federal budget deficit shrinking by 40 percent over the past two years, a turnaround the president hopes will strengthen his push for further tax cuts.

Bush hailed the dwindling deficit as a direct result of “pro-growth economic policies,” particularly huge tax cuts enacted during his first term. “Tax relief fuels economic growth. And growth — when the economy grows, more tax revenues come to Washington. And that’s what’s happened,” Bush said.

Economists said Bush was claiming credit where little is due. The economy has grown and tax receipts have risen at historic rates over the past two years, but the Bush tax cuts played a small role in that process, they said, and cost the Treasury more in lost taxes than it gained from the resulting economic stimulus.

“Federal revenue is lower today than it would have been without the tax cuts. There’s really no dispute among economists about that,” said Alan D. Viard, a former Bush White House economist now at the nonpartisan American Enterprise Institute. “It’s logically possible” that a tax cut could spur sufficient economic growth to pay for itself, Viard said. “But there’s no evidence that these tax cuts would come anywhere close to that.” (Full Story)

Viard points out a common fallacy among those on both sides of the political aisle when it comes to cause and effect as a result of policy changes. Just because a policy occurs at the same time as some activity occurs in the economy does not mean that the policy caused that activity to occur. The relevant question, as Viard points out, with regards to measuring the role that the policy change played in that economic change is “What would have happened without the policy?”

But both sides are guilty of such rhetoric. Another recent example of this fallacy of causation versus correlation is when many progressives claimed that raising the minimum wage can actually increase employment as they point to the fact that following the hikes in the 1990s, the number of jobs increased. Because job growth would have occurred, regardless of the hike, the truly relevant question of the role of that policy change would be “What would the number of jobs have been without the increase?”

Almost surely, federal tax revenues would have increased from 2002 – 2006 relative to their low 2001 level, even without the tax cuts. If you look at many of the key provisions of the tax cuts, many would have little economic feedback at all, especially the initial 2001 tax cuts that included rebates and an expansion of the child tax credit, which are really no different than the government having an agency just write billions of dollars worth of checks to families, which would merely be called government spending.

Cutting marginal tax rates on labor would have a larger feedback effect in terms of additional economic activity being generated than these credits/rebates, especially because of the progressivity of the federal income tax code which means we rely on the more pro-cylical income of high-income individuals, but labor is still fairly inelastic nationwide, meaning the tax cuts on ordinary income at their given rates would still cost the Treasury revenue. On the other hand, the revenue losses associated with the 2003 round of tax cuts, which included cutting dividend tax rates, may not be as large as static estimates would suggest. These tax cuts could have a significant level of feedback because investment is highly elastic relative to labor, and thereby long-run revenue losses are much smaller compared to cutting taxes on wage income.

For more on the debate over dynamic scoring, check out our previous blog posts on the issue here, here, and here.

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