Thursday, October 13, 2011

Do tax cuts pay for themselves?

Since this is an argument commonly made by conservatives, that tax cuts will spur economic growth and therefore pay for themselves, it's always worth noting a recent look at the issue. Simon Johnson, former chief IMF economist, reviews a few studies in a New York Times column today and provides an answer:
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.

Nevertheless, a version of this idea, under the guise of “dynamic scoring,” has apparently surfaced in the supercommittee charged with deficit reduction — the joint Congressional committee with 12 members. Dynamic scoring sounds technical or perhaps even scientific, but here the argument means simply that any pro-growth effect of tax cuts should be stressed when assessing potential policy changes (e.g., reforming the tax code). For anyone seriously concerned with fiscal responsibility, this is a dangerous notion.
He cites two studies, one co-authored by Professor Gregory Mankiw, a former Bush economic adviser which finds:
...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.
Offset at best a portion of the revenues lost. Further:
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.
Another good resource on this question, Mark Thoma's blog which has dealt with it extensively.