Treasury Report Details Economic Impact of Permanent Tax Cuts

July 26, 2006

The Treasury Department on Tuesday released a report estimating the macroeconomic impact of making the current federal income tax cuts permanent. Their conclusion is that the tax cuts will increase long-run economic growth as long as they are financed through spending cuts and not through future tax increases. Here is the report’s conclusion from the Treasury Department’s Office of Tax Analysis:

The analysis presented in the paper suggests that permanently extending the President’s tax relief enacted in 2001 and 2003 likely would lead to a long-run increase in the capital stock and an increase in national output in both the short run and the long run. If the revenue cost of that tax relief is offset by reducing future government spending, the increase in output is likely be about 0.7 percent under plausible assumptions. If, instead, the tax relief is extended only through the 14 end of the budget window (i.e., it is temporary), the tax relief would increase national output in the short run, but long-run output would decline as future tax rates increase.

The analysis also suggests that if only the portions of the President’s tax relief that primarily reduce marginal tax rates are extended (i.e., the lower rates on dividends, capital gains and the top four ordinary income brackets), it is likely that output would increase regardless of whether the revenue cost of the relief is financed through a future reduction in government spending or a future increase in tax rates, although the increase would be considerably larger if government consumption is reduced.

That final paragraph of the report is interesting because it shows that the better way through tax policy to increase long-run economic growth is to target directly at marginal tax rates, whereby people make their economic decisions, and not to mess with credits, deductions, phase-outs, phase-ins, etc, which have little economic value.

Overall, the report encompasses many theories of the macroeconomy in that it states that deficit-financing tax relief gives a short-term boost to GDP (Keynesian), yet it also indicates that government distorting intertemporal capital flows across a given time period could end up lowering long-run economic growth.

In terms of the revenue impacts and the Laffer Curve, the report assumes that these tax cuts do not increase government revenues in the long-run. Otherwise, there would be no need for spending to be cut back or future tax increases in order to finance the tax cuts. In other words, the report assumes that we are indeed on the left side of the Laffer Curve. However, the report does suggest throughout that cutting taxes on investment income has greater economic gains than cutting taxes on labor income. Equity issues aside, this would then imply that the revenue losses associated with tax cuts are much greater for cutting labor taxes than cutting taxes on investment income. This would make sense as it is pretty much agreed upon in economic circles that investment decisions are much more sensitive to taxation than are the decisions of individuals as to whether or not to work and how much.

For more on the issue of dynamic scoring, check out a previous post that includes links to a multitude of papers on the topic. Also, for former CBO Director Douglas Holtz-Eakin’s take on the issue of dynamic scoring, listen to a recent podcast interview in which he gives his take on the topic.


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