Update 2:
Sorry for responding this way rather than in the comments. I won't have a chance to plug in my laptop until Tuesday, so I can't punch through the firewall properly.Brian says in the comments:
"(1) by the second quarter of 2003, the economy would have created as many as 1.5 million fewer jobs and GDP would have been as much as 2 percent lower, and (2) by the end of 2004, the economy would have created as many as 3 million fewer jobs and real GDP would be as much as 3.5 to 4.0 percent lower."
That's a BIG boost to the economy which is likley to have been a big boost to tax revenues. To take into account the effects of the tax cuts, you have to include this extra 3.5 to 4.0% in your calculations. In other words the .7% is in addition to the boost we've alread had.
Not true. The 3.5% to 4.0% growth is classic Keynesian fiscal stimulus. It's short-term. That growth would have happened anyway, but perhaps later. You could also acheive the same effect through deficit spending rather than tax cuts. Both measures pump money into the economy.
For long-term growth you need to get people to change their behaviour, presumably in response to greater rewards for their work. That's where the .7% comes from.
I also notice that the report predicts that NOT extending the tax cuts would result in a decrease in GNP of .9% for a total difference of 1.6% between letting the cuts expire and making them permanent.
This is a misreading of the report. The .9% decrease would result if the tax cuts were extended without cutting spending. Since the deficit would then spiral out of control, a future tax increase would be needed. Thus you would be financing the near-term tax cut with a future (larger) tax increase. The net result is a .9% drop in GNP.
From near the end of the report:
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 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.
You see that both the .7% increase and .9% drop assume that the tax cuts are extended. In the first scenario the tax cuts are accompanied by a cut in spending, and are thus permanent. In the second scenario the tax cuts are financed by deficit spending, so there will need to be a larger tax increase in the future (beyond the budget window) to bring the deficit down.
Update:
I can't post comments from where I am (stuck behind the Great Firewall), so I'll respond to Richard's comment here. Richard says:
it seems there are major logical flaws in this analysis. First, is Mr. Furman associating economic growth with gov't revenues? Increased economic activity doesn't necessarily mean increased tax revenues (though it's usually the case). Second, he seems to include gov't spending in the equation somehow, which is a separate issue from whether tax cuts stimulate the economy or not.
For the first point: I'm not sure what you're getting at. The bottom line is that the total benefit of a tax cut extension, under ideal circumstances, is a .7% increase in GDP. Not .7% annually, but .7% total. This is not enough have the tax cuts pay for themselves.
For the second point: You can't omit government spending. If you cut taxes then you must finance it somehow, and this will have an effect on the economy. The report considers several scenarios, and the best case - financing the tax cut through lower spending - produces a 0.7% increase in GDP. The other options produce worse results. Considering only the tax cut without including the other side of the equation would be meaningless.
Original Post:
Some politicians, either through ignorance or outright dishonesty, continue to claim that tax cuts pay for themselves. Unfortunately the news media seem unable to call them on it. Jason Furman attempts to counter the spin-doctors and correct poor reporting of the U.S. Treasury's recent study:
Contrary to the claim that the tax cuts will have huge impacts on the economy, the Treasury study finds that even under favorable assumptions, making the tax cuts permanent would have a barely perceptible impact on the economy. Under more realistic assumptions, the Treasury study finds that the tax cuts could even hurt the economy.
[...]
Some of the reporting on the Treasury analysis has made a basic mistake. The Treasury study found that making the tax cuts permanent would increase the size of the economy over the long run — i.e., after many years — by 0.7 percent, if the tax cuts are paid for by unspecified cuts in government programs.
[...]
Several news reports, however, mistakenly said that the Treasury found that making the tax cuts permanent would lead to a 0.7 percentage point increase in the annual growth rate.
[...]
The featured results in the Treasury study are based on the assumption that government programs are cut sharply starting in 2017 in order to pay for the tax cuts. In total, government spending would have to be reduced by the equivalent of about 1.3 percent of GDP after 2017. That would be equivalent to cutting domestic discretionary spending in half. This is substantially larger than the budget cuts the President has proposed. Thus, the featured Treasury estimates are estimates of the long-term economic effects not of the tax cuts per se, but of the combination of the tax cuts that the President has proposed and unspecified, deep program cuts that he has not proposed.
The article touches upon, but doesn't directly address the issue of overall utility for the public. The potential long-term gain of .7% of GDP is not only fairly small, it must also be balanced against the utility that public loses because of the needed cuts in program spending. Citizens might well be happy to lose that .7% of GDP for the benefit of better health care or education.
32 comments:
I haven't read the article, but from what you have put up, it seems there are major logical flaws in this analysis. First, is Mr. Furman associating economic growth with gov't revenues? Increased economic activity doesn't necessarily mean increased tax revenues (though it's usually the case). Second, he seems to include gov't spending in the equation somehow, which is a separate issue from whether tax cuts stimulate the economy or not.
I thought it might be better to read the actual report rather than a biased interpretation of the report:
http://www.treas.gov/press/releases/hp25.htm
Jason Furman's analysis is taking one item from the report and building on it. Specifically he's using the .7% expected FUTURE additional growth and using that as the only data point. He's completely ignoring items such as:
"Specifically, Treasury found that, without enactment of the Economic Growth and Tax Relief
Reconciliation Act of 2001, the Job Creation and Worker Assistance Act of 2002, and the Jobs
and Growth Tax Relief Reconciliation Act of 2003: (1) by the second quarter of 2003, the
economy would have created as many as 1.5 million fewer jobs and GDP would have been as
much as 2 percent lower, and (2) by the end of 2004, the economy would have created as many
as 3 million fewer jobs and real GDP would be as much as 3.5 to 4.0 percent lower."
That's a BIG boost to the economy which is likley to have been a big boost to tax revenues. To take into account the effects of the tax cuts, you have to include this extra 3.5 to 4.0% in your calculations. In other words the .7% is in addition to the boost we've alread had.
Is this enough to make the tax cuts "pay for themselves"? (I really hate that phrase, it assume the government is entitled to the money...) Maybe, maybe not. I don't care. The fact is that the economy grew at a good rate AND the government is collecting more total taxes than before the rate cuts. Both were actions that were predicted before the tax cuts and both were desirable outcomes.
I also notice that the report predicts that NOT extending the tax cuts would result in a decrease in GNP of .9% for a total difference of 1.6% between letting the cuts expire and making them permanent. This also is not considered in Mr. Furman's rebuttal.
I'd say Mr. Furman is the one who is making "exaggerated claims about the tax cuts".
Ok, I'm not sure what's hard to understand about my question. If the question is whether cutting taxes leads to more tax revenues than had you not cut taxes, why would you include spending? You mention having to "pay" for the cuts, but that's a separate issue.
For a moment, let's think of the gov't as a business. An intensely basic overview of a company's profitability is their revenues minus their expenses. Assume the product is the economy and the price is taxes, with R&D being gov't services (I'm trying to keep this example from getting too complex, really!). Lowering price (taxes) will always result in more product (the economy) being sold, but will the increased sales be enough to offset the lower profit margin? This is independent of how much is spent on R&D (services), and factoring it in fails to isolate the price variable.
This is a very common flaw I hear concerning the '80's as well. People claimed the tax cuts cost the gov't money, when in fact they spurred on tremendous economic gains and increases in tax revenues. At the same time, however, Congress spent tremendous amounts more, which surpassed the increases in revenues, leading to higher deficits. It's dishonest to say the tax cuts hurt revenues, because revenues increased fairly dramatically.
Richard: Your analogy doesn't work at all. The economy isn't a product, and even if it were, the government doesn't sell it.
Lowering taxes or increasing government spending pump money into the economy and will provide at least a short term boost to the economy. Nobody disputes this. It's called "fiscal stimulus" and was strongly advocated by John Maynard Keynes as a way to smooth the boom-bust cycles in the economy. Keynes, as you probably know, is considered an evil Liberal economist by many conservatives. His theories fell out of favour after the stagflation of the '70s, with Keynesian economics being blamed for much of the problem. (I think Keynes has gotton somewhat of a raw deal. I think there's still a place for fiscal stimulus, but I agree that it's role is limited.)
Your charactarization of the effects of Reagan's tax cuts is incorrect. The combination of tax cuts and increased spending did pump the economy, but revenues never recovered to the level they would have been without the cuts. In the end Bush I was forced to increase taxes (remember "read my lips, no nude faxes").
I've pointed this out many times before to both you and Brian, but you both seem to turn off your brains when I mention it: GDP grows naturally dollar terms because of 1) regular economic growth (that happens regardless of tax cuts), 2) inflation, 3) population growth. Any figures you can produce that appear to show tax cuts causing greater tax revenue can be explained by a combination of these factors.
The flip side of your Reagan arguement: why don't you give congress credit for increasing tax revenue? They increased spending, and tax revenue rose. Isn't that proof that government spending causes tax revenue to rise?
The reason you can't separate direct effects of tax cuts from how those cuts are funded is because the report is trying to predict the effects of tax cuts on a real economy. In the real world the cuts must be paid for somehow.
I could also author a report that shows that increasing government spending by $1 trillion/year will boost the economy, assuming you don't actually have to raise the money somewhere. I'm sure I could demonstrate amazing benefits, but it would be useless since you can't actually increase spending without financing it somehow.
The same thing applies to cutting taxes.
... Ami.
[ps. Actually, you can increase spending for "free" by printing money, but the resulting inflation is equivilent to a tax on everybody who has savings.]
"Richard: Your analogy doesn't work at all. The economy isn't a product, and even if it were, the government doesn't sell it."
Really? How does the economy and gov't tax and spend policy NOT fit the Law of Supply and Demand? You yourself admit that decreased taxes and increased spending can spur the economy, so where does the analogy fail? We can differ about the benefit or cost, but we're agreeing that it's operating under the basic function of economics.
My analogy is valid, Ami, though it's significantly more complex than one product and one price. Some tax cuts would not produce a significant increase, while others might. What I DO know, however, is that if you want to understand the effect of a specific action (in this case, raising or lowering taxes), the only way to really do that is to isolate your variable and test it and it alone. Insisting on considering other variables (gov't spending) means you aren't really testing your original hypothesis, and THAT'S the logical flaw both you and Mr. Furman insist upon.
I'm familiar with Keynsian Theory. The true problem with his economic theory is that, once gov't spends money to improve the economy, there's almost no chance they'll actually reduce it like they're supposed to when things are better. Otherwise, it's a workable model for a healthy economy.
As for "revenues never recovered to the level they would have been without the cuts," that's a very tricky thing to prove. We were in an economic downturn in the late '70's and gas lines were everywhere. Perhaps the economy would have turned around on its own (economies tend to be cyclical), perhaps it never would have. It's supposition at the very least.
"The reason you can't separate direct effects of tax cuts from how those cuts are funded is because the report is trying to predict the effects of tax cuts on a real economy. In the real world the cuts must be paid for somehow."
Again, this "paid for" line is only relevant if you can isolate that, in fact, revenues are decreased because of the tax cuts. Your only response to it is, "well, if you factor in expected economic growth, inflation, and population increases, it would show you're wrong." First, many factors could throw those figures off (9/11 crippled "expected economic growth," regardless of whether there were tax cuts or not), inflation is typically a lagging symptom, and population growth is meaningless to the equation if the economy can't handle it.
Ami,
Good luck with the great firewall. I agree with your analysis of the report, but because of the following statement near the end…
*First, this model does not account for short-term deviations in output from potential GNP. This implies that the model does not capture some of the short-run benefits of tax relief when it occurs at a time when the economy is below its potential, which occurred with the 2001 and 2003 tax relief. Section 2 of this Report describes a separate Treasury analysis of the effect of the President’s tax relief that includes these cyclical effects.*
…I think the whole report is worthless when looking at the long term.
Correct me if I’m wrong Ami, but doesn’t most modern theory need to take this into account!? THAT is exactly what the supply-siders posit, i.e. that if taxes go up, people don’t work up to their full potential because it is not worth as much. I would argue that while there may be only a .7% rise in “potential” GDP, the actual rise will be much higher, as we will be operating at, say, 80% of potential instead of 75%. (I’m just guessing at numbers, but with 0 wage taxes, and no new ones, I’d probably be willing to work another 2-3 hours a day.)
I also don’t think the report tackled the issue of an eternal deficit very well. Many Americas, and most congress critters seem, to think it really is OK. The report pretty much says “You can’t do that, so we’ll just assume it won’t be tried” This also plays with the second stated weakness of the report—fixed international investment.
Lastly, I think there needs to be some sort of examination of how accurate these studies tend to be. That is, according to the table on this page:
http://www.cbpp.org/10-6-05bud3.htm
The government cannot even predict revenue one year out with 1% accuracy.
About your analysis, Ami, The article touches upon, but doesn't directly address the issue of overall utility for the public. The potential long-term gain of .7% of GDP is not only fairly small, it must also be balanced against the utility that public loses because of the needed cuts in program spending. Citizens might well be happy to lose that .7% of GDP for the benefit of better health care or education”
Individuals are presumed to have the extra money in their pocket in addition to the extra GDP. That is, (assuming equal income, taxation and contribution to GDP for a moment) If a $100 program were cut and a $100 tax break were given, then the tax payer would have $100.70 more than last year. The questions have to be, “Was the program worth $100.70?” and "could we get it for less than $100.70?"
On a side note, my assumption brings up many issues, most of which revolve around the selection of the program to be cut.
Another thing I didn't realize, the 0.7% increase is in GDP, not tax revenues. THat means that if the GDP grows in an area that is not taxed at exactly the average amount, it could easily change tax revenues more or less than .7% one way or the other.
Ami, that 3.5 to 4.0% increase is in real GDP and has already occurred. I'm not suggesting that we will continue to get and additional 3.5 to 4.0% in future years, but we have increased GDP. We aren't giving that growth back. The 0.7% is the additional stimulus if the tax cuts remain permanent. Or are you suggesting that the GDP will slide by 2.8% to 3.3% long term in order to make the total effect only .7%?
Fiscal stimulus is temporary in that it give a boost to the rate of increase only for a while. But the real amount the economy has expanded doesn't go away long term. Any future growth is on a higher base.
IE: If the economy were 100 without the stimulus and grew 4% due to it, the new value of the economy is 104. Any future growth is based on the 104, not the 100. The rate of future growth may only be .7% but that will give a total GDP of 104.728 instead of 100.7.
Brian (and others): I think your point cuts to the heart of the confusion. I only have a few minutes to answer, so I'll just tackle this and tie it in to Richard's and Stryker's comments on the weekend.
The 4% (or so) of growth due to fiscal stimulus is temporary. (At least most of it.) Not a one time boost (as you suggest), but rather a boost that will be offset by slower growth in the future.
Imagine the long-term growth trend of the economy as an upward sloping line, rising at approximately 3.5% per year. This line represents the capacity of the economy.
Now imagine another line that wiggles up and down, sometimes above and sometimes below this capacity line. This line represents the economic cycle. When this line is too far above the capacity there's inflation, and real production doesn't go much higher, when this line is too far below then there's unemployment and often a recession.
The slope of the capacity line is largely determined by technological change. The "level" of the capacity line is largely determined by the structure of the economy, including how much people choose to work.
The wiggly line (the actual GDP) is a combination of the capacity line, plus transient factors such as consumer sentiment. You might imagine that the wiggly line is attached to capacity line by an elastic - it can move independantly, but the further away it gets from capacity the greater the pull towards the long-term trend.
Now if you see a 4% rise in GDP, has the wiggly line just been pulled up or down? Has the slope or the capacity line changed? Has the capacity line shifted up or down?
It's kind of hard to tell for sure without watching the line for 10 years or so, but since we have a lot of historical data, and a reasonable idea of what causes the various effects, we can make a decent guess.
Since there's no reason to think that technological progress has suddenly increased dramatically, we can probably conclude that the slope of the capacity line hasn't changed much.
Distinguishing between the other two effects is more difficult, but we know what to look for. For tax cuts to cause a structural change (an upward shift in the long-term trend) we'd need to find evidence that people are responding differently to incentives. They must be more willing to enter the workforce, or somehow be using productive resources more effectively. There's little evidence to support this.
In contrast, there's a lot of data on how fiscal stimulus effects the economy from previous business cycles. The bulk of that 4% appears to be similar to similar situations previously: people have more cash in their pocket so they spend more, but the effect will disappear by the next economic cycle.
This is the basic limitation of Keynesian demand management: it can smooth out the bumps and valleys in the economic cycle, but it can't change the overall trend line.
... Ami.
I should probably re-read every thing before posting, but time is short.
Brian, I think the 0.7% is in addition to normal growth. If expected growth before was 3.5%, it will now be a hare more, leading to 0.7% MORE than would be given by the 3.5% annually. THat would explain how we could have high growth in the short term, with lower growth in the long term.
Ami,
While you are right about the 3.5% over the last 40 years, but hasn't that number been creeping up? Wasn't it 3% in the first half of this century, and lower before that?
Ami,
Your theory suggests that there is a steady rate of long term growth no matter what you do. You can make short term adjustments, but anything you do now that increases or decreases growth will automatically adjust back the other direction to make up for it.
Frankly I don't buy it. Capacity for production increased along with the economy. The evidence for this is the job growth that went with it. Adding those workers to the economy produced additional capacity (more workers can produce more goods as services).
If you're refering to factory output. Factories that were under utilized did increase utilization. Those that were running at near maximum output expanded (which creates more economic activity with builders, etc.). But having unused factory production capacity isn't a garantee of future growth, in many cases it's a sign of a troubled business.
It does appear we're going to slow down, but it's not a backlash from the previous growth. It's from the Fed moving too far too fast on intrerest hikes...
Brian: It's not that you can't do anything. Just that fiscal stimulus (tax cuts alone, or spending cuts alone) won't do much.
You can change the structure of the economy - this is the supply-side thesis - by reducing the size of government: you must decrease both taxes and spending. Obviously you don't get the Keynesian fiscal stimulus in this case, since your tax cuts are accompanied by a cut in spending this nets out to zero. But you can hope for some better utilization of existing resources.
Unfortunately for the supply-siders, there are diminishing returns. Sure if you live in a communist country you can get a huge boost by moving towards capitalisim - witness China. But for modern Western economies like the U.S. or Europe, most of the gains have already been had. Hence the .7% long-term increase given in the report.
I know it's appealing to imagine that growth can continue at 5% forever if only those damn economists would leave interest rates alone, but it just doesn't work that way. Even the most automated factory (or Starbucks, or building site) needs a certain amount of people to run it. That number gradually declines as technology improves, but not quickly enough to keep the economy in a perpetual boom. (And if it did you would constantly have large numbers of displaced workers, so the economy wouldn't be able to operate at capacity anyway.)
And I don't actually believe that there's nothing that can be done about increasing the long-term rate of growth. My major is "technology management and policy", so obviously most people in my field think "policy" has a role in improving technology. But the issues here aren't about fiscal or monetary policy, but rather patent and copyright law, private vs. public research, and so on.
... Ami.
Ok, you propose that the economy will automatically operate, over time, at a certain level of efficiency, so short-term growth will be offset with future economic slowdowns (business cycle and all) (please correct if I misunderstood). I respectfully dissent, as this would mean that all economies should perform at roughly the same level over time, and they don't.
You could argue nat'l resource distribution, but Japan is an island without many resources, and they have a significant world economy. The Middle East would be a major player in the world economy due to oil, but it isn't. Need I go on?
Assuming for a moment your theory is correct, why wouldn't the gov't just tax our wealth 100%? As it wouldn't impact the economy long-term, the revenues from such a plan would certainly outweigh the negatives, wouldn't it?
Richard: You're overgeneralizing what I said. I said two things:
1) I said that short-term fiscal stimulus - meaning government tax-cuts alone or spending increases alone - don't have significant effects on long term growth (and often they can harm long term growth, since they can lead to high government debt). In fact they don't even have significant medium-term effects (say longer than two business cycles).
2. I said that the supply-side idea of smaller government can't, by itself, have a significant effect on long-term growth in modern economies. I'm allowing for some effect - the treasury estimated .7% for the U.S., which sounds reasonable - just not a lot. I'm also limiting this to modern economies.
Obviously I'm not talking about what happens when you tax 100% of the economy. Modern economies tax something like 17-50% of GDP. In that range the elasticity of supply for labour and investment is relatively low. (And you can also tweak the tax structure to try to reduce the distortions caused by taxation.)
I'm not sure what you're trying to say about the Middle East - I'm sure you know about the other factors that have hurt the economies there. Corruption, war, colonialism - and things that followed from those - poor infrastructure, poor education, etc.
The modern economies (say the OECD) have a few things in common:
1. they're market economies
2. their tax rates are in a range that does not significantly discourage participation in the economy
3. they're politically stable
4. their infrastructure isn't being destroyed by war
5. they have modern financial systems
Probably there are more, but I think this covers the biggies. So given these things, yes, these economies do grow at roughly the same rate over the long-term. One or the other may remain poorer or richer than the rest because of structural differences, but they will mostly move together.
That still allows for some pretty big effects due to structural differences. Some cultures value their vaction time more, so they will work less. Now that I'm used to five weeks vacation in Finland, for example, I don't think I can ever go back to a mere two weeks. But that effects the level of output, not the long-term growth rate. So the hit Finland takes from this cultural choice is one-time.
Similarly, Finland has strong social programs that will tend to increase the unemployment rate. Many people choose other alternatives rather than accepting low-paying jobs. If the Finns decided that social programs weren't worth this hit, then they might gain 10% (just a guess - I don't know what the real gain would be), but then they would stabilize at the new level and long-term growth would again be about the same.
I don't know much about the U.S. tax system, but I've heard it's a little bizarre and discourages investment. So there could be some gains from changing the tax structure. Those would also be one-time gains, however, and wouldn't effect long-term growth.
If you want to effect long term growth then tax breaks for R&D might help. Or more funding for post-graduate education. Hard to say for sure - that's a whole area of research on its own.
I should also qualify my idea of "long term" a little. The whole model rests on this this somewhat, and the meaning isn't precisely defined. I'm considering "long term" to be something like 50 years, and I think that's reasonable for the U.S. and Europe that are starting from a pretty advanced level.
For a country like India (or worse - most of Africa and M.E.) the starting point is much lower. Even if you could do everything right, it would take more than 50 years to overcome the lack of education and infrastructure in these places. That means that if India does everything perfectly they can achieve an above average growth rate for over 50 years, until it reaches a level of development similar to the rich countries.
China is furthur along in this, so I figure they've got less than 50 years of super high growth left, and then they'll be constrained by technology like everybody else.
... Ami.
Ok, I think I understand a little better what you're trying to say, then. I appreciate the explanation.
Concerning US tax laws, you're right that it's complex. My understanding is that tax returns for large businesses are in excess of 1,000 pages, due to the complexity of the laws (not to mention state income taxes, which have their ow n complexities and are likely hundreds of pages). Individuals can expect, at a minimum, two pages (if they live in one of the seven(?) states without an income tax of their own) where it isn't really clear what they're asking you for, and likely a handful more if they do anything more with their life than work one job, rent an apartment and buy groceries.
Anyway, back on topic. While it's true that, over a long enough time period let's say your 50 year time frame), you can smooth the data to see an overall growth rate for the time period, you aren't really properly studying the impact of any specific tax policy, as policy changes significantly during the period in question (my understanding is that US tax law has been amended some 17,000 times since Pres Reagan's cuts in '82).
Now, you claim that taxes in a certain range have a negligible/imperceptible impact over the long term, as short-term gains are negated by slowdowns later on.
Has there been a study to back this up, (because I've never heard of one, but I"m hardly an authority) or is this hypothesis? I'd assume you could take, say, 100 years of economic growth, factor for population growth, inflation, and so on, then compare the real value of economic growth over 50 year periods, probably incremented on a 5 year basis (comparing 1901-1950 growth to 1906-1955, to 1911-1960, and so on), but could also be done on a yearly basis. Something like that would be pretty convincing, but I don't otherwise buy the argument, as it seems contradictory to other evidence I've seen concerning stock market valuations over time (which may or may not be a good indicator in and of itself).
Richard,
There are three main schools of economics that we are discussing here, classical, Keynesian, and Laffer (supply-side).
Classical economics really only deals with the “long term” because there is no accounting for (what we engineers call) non-ideality. That is, there is no accounting for friction in the market, the length of unemployment while looking for a new job, etc. This isn’t really talked about as much.
Keynesian economics is based on the idea that “In the long term, we are all dead.” Keynes took into account the fact that there are frictions in the economy, but government fiscal policy can ease them along by raising and lowering taxes and spending independent of each other (that is run a deficit when the economy is not doing well to boost things along, but pay it back when the economy is doing better.)
The quote by you of Ami -- “Now, you claim that taxes in a certain range have a negligible/imperceptible impact over the long term, as short-term gains are negated by slowdowns later on.” – Is classic Keynesian theory. It has been proven to a certain extent during the ‘30s and 40s.
Laffer’s theories are a bit different in that they aren’t dealing with short-term stimuli per se, but rather are trying to change the whole economy under the theory that Private businesses are more efficient (grow better) than governments. It would follow that if both gov’t spending AND taxation are decreased, the economy will grow closer to the ideal “maximum production level”. Strict Keynsian economic models don’t take government size into account.
There really haven’t been any studies about a fourth option, which is what the neo cons are doing now. That is trying to use Keynesian stimuli (deficit spending) indefinitely. I think some of our disagreements are that we are trying to fit the US’ policies under Kensian or Laffer models, but we really can’t, unless the government actually decreases its size, or raises taxes.
Stryker: While I agree that what the Neo-cons are trying is perpetual deficit spending, I don't think there's any economic theory behind it. They claim to be supply-siders, but the policy isn't supply-side. The closest thing I've ever heard to a theory is the "starve the beast" idea. Basically if you bankrupt the government then there will no longer be any money for any government services, so maybe you can achieve smaller government that way. It may actually work, although it won't be a pleasant experience for Americans.
Richard: Everything in economics is theory, and generally less supported than the hard-sciences. But the basic outline I've given is pretty widely accepted. There's no single study that could capture this effect, but a large body of theory and empirical evidence. The details are of course controversial, but the overall idea not so much.
The general direction of these studies is to try to think of the mechanisms that might cause growth, and look for those happening. So for fiscal (Keynesian style) stimulus to work over the long term then you must see some sort of shift in supply - for example more willingness to work. If the growth is simply people buying more stuff (the mechanism that Keynes was looking for) then that's not long-term. Since there isn't actually any more stuff to buy at the top of the business cycle, this willingness to spend more just gets eaten up by inflation.
You need to find evidence of people being more willing to enter the work force. This is actually measurable on the micro level. We know how much people make, and we know how much they work, so we should be able to determine how much more willing they are to work given an increase in take-home pay. Those 17000 changes to tax policy you mention provide lots of natural experiments. Just look at the people who were affected by those policies and see if they worked more or less than before.
I haven't studied the literature here (not my specialty), but Google scholar lists (at least) hundreds of articles related to elasticity of labour supply. I'm sure you can find dozens supporting any given spin you want. I'm not really qualified to guide you through them - the explanation I gave is pretty textbook. I haven't read the literature myself.
Answers.com has a good summary of the exogenous growth model (which is what I described). I should have looked for something like this earlier - could have saved myself a lot of typing.
Although there are criticisms of the model, I'm not really aware of any serious criticism of it's conclusions per se. Rather people want to know more than the model offers. The model doesn't actually address _why_ technology advances, and obviously that's pretty important.
... Ami.
Ami,
I've read and re-read the paper several times and I still read it as projecting .7% additional growth if the tax cuts are made permanent. Though I can understand how you could read it to mean total growth when they use terms like "ultimately" in their summary.
There are several comments suggesting that the economy had been performing below its potential in 2001-2003 and that the tax cuts brought the economy up to its potential (which sounds very Keynesian). This supports your short term stimulus argument.
But the paper clearly states that the model's base year is 2007. That tells me that they are modeling only future growth from making the cuts permanent, not total growth from the 2001 and 2003 cuts. They are not including growth to the present date in their calculations.
Brian: You're correct that their model is forward looking only. The brief discussion of growth-to-date is a summary of previous research, and doesn't directly relate to what they're trying to show with this paper.
So going forward, they provide three alternatives:
1. the baseline is that tax cuts are not extended, so in effect there is a tax increase. So "0%" in this context means that taxes increase from their current level.
2. if tax cuts are extended for the current planning period, but there are no spending cuts, then there will need to be a future tax increase. This results in a .9% decrease from the baseline. So it's better to raise taxes now (option 1) than to wait and raise them later (option 2).
3. if tax cuts are extended indefinately and accompanied by a spending cut then the model predicts a .7% increase.
Your point about past increases isn't addressed directly, but it clearly says in the second paragraph of page one " The tax relief enacted in 2001 and 2003, together with
reductions in short-term interest rates by the Federal Reserve, helped stimulate economic growth
and move the economy out of the 2001 recession more quickly." This is very much in line with the Keynesian prediction. The economy didn't reach a higher level than it would otherwise, it simply transitioned out of the recession more quickly. The 3.5 to 4% difference they site for 2004 has probably all but disappeared (or if not, it will probably disappear soon as inflation picks up).
[Also note that the 3.5-4% is from a tax cut and and interest rate cut, not from tax cuts alone.]
If you consider things the other way, if tax cuts created 4.2% (3.5 + .7) of permanent new growth, wouldn't you expect a greater negative impact from reversing the tax cuts (option 1)? It seems awfully strange that a tax cut could bring 4.2% of permanent growth, but a tax increase only cuts growth by .7%. If true it would be great discovery, but I doubt that sort of free lunch really exists.
... Ami.
Hi Ami,
The reason the tax cuts can create 4.2% growth while letting them expire will cause only a .9% drop is because the economy was performing below it's potential (and was trending downwards) after the dual hits of the .COM tulip bulbs and the 9/11 attacks.
We had started a recession in late 2000/ early 2001 and with the attacks could possibly have entered a full fledged depression without the stimulus provided by the tax cuts and fed actions. It is unlikely that just letting the tax cuts expire will cause the economy to enter a recession (though it will slow growth by the estimated .9%). The future tax increases they are talkinig about are compared to current rates. They are considering the expiration of the current cuts to be future increases. From their report: "If the tax relief is financed by future tax increases – that is, if the tax relief is temporary – it may well result in lower output in the long run."
But if you want to argue that the US government also needs to cut spending, I'll strongly agree with you.
Brian: No no no. The paper is about whether or not to extend the tax cuts, which are currently temporary. So the status quo - what will happen if nothing else is changed - is that the tax cuts will expire (in other words, the taxes will be increased above the current level). That's the baseline of 0%. The .9% decrease is if the tax cuts are extended, but there are no spending cuts, so taxes will need to be increased at some unspecified date beyond the current budget period. The .7% increase is if the tax cuts are made permanent, and financed by some unspecified future spending cuts.
Yes, the 3.5-4% growth was because the economy was performing below capacity at the time. I definately agree with that. But the economy would eventually have recovered on its own, and thus reached something close to full capacity. This is why I say that the 3.5% increase is short term. It doesn't mean anything beyond the current business cycle.
... Ami.
We'll have to disagree about the paper's base line... I think it clearly says the increases it's talking about are the expiration of the tax cuts. In fact I quoted them saying just that...
As to the short term not mattering, I disagree there too. The loss of jobs accompanying a recession causes unneeded suffering on the people. It also puts an even larger strain on government services (unemployment, medicaid, food stamps, etc) than would occur if the recession is made shorter or avoided. In the long run, the economy may have eventually recovered to where it would have been anyway (I think there's a flaw in that model, but I can't prove it), but there would have been great damage done to the country in the mean time.
Brian: Sorry, but there's really no room for disagreement about the baseline. I'll try one more time to illustrate.
At the bottom of page nine there is a heading "Tax Relief Financed with Future Decrease in Government Spending". The paragraph begins:
For this set of results, the model assumes that government consumption purchases (i.e.,
government spending) adjust after 10 years to stabilize the government debt-to-GNP ratio.
So this is clearly the "tax cuts funded through spending cuts" option. If you keep reading that section you find the eventual growth of .7%.
The next section titled "Tax Relief Financed with Future Increase in Taxes" is on the bottom of page 11. The first paragraph with the key words bolded:
Under this financing assumption, all average and marginal tax rates on labor and capital income
are changed by the same proportion in each year after the 10-year budget window in order to
maintain the baseline amount of government services and to maintain the government debt-to-
GNP ratio at the value it takes at the end of the budget window. In effect, the tax relief is
modeled as temporary, as it is more than reversed in the future by across-the-board, proportional
tax increases.
So in this model the tax cuts are extended beyond their current expiry date, but taxes must increase after 10 years to compensate, since there is no cut in spending. This is the .9% decrease case (which you can see explained if you read the rest of the section).
I didn't mean to imply that short-term benefits were unimportant. But they can only form a coherent economic policy if they're really short term. If you don't increase taxes again after a downturn, then you don't have the option of using deficit spending as stimulus again in the next cycle. So if you value the benefits of short-term stimulus then you should be campaigning to have the tax cuts reversed, so you can enjoy the stimulus again in the next cycle.
... Ami.
"So if you value the benefits of short-term stimulus then you should be campaigning to have the tax cuts reversed, so you can enjoy the stimulus again in the next cycle."
No, I think I'll be campaigning for spending cuts so we can get the extra .7% growth and still have the option of deficit spending stimulus in the next cycle. 8*)
Ami, perhaps I should give credence to the idea that an economy, given efficiency, will only produce X over a given period of time (say, 20 years, 1 business cycle, or some other finite time period), regardless of tax rates. However, I don't, and unless I see something more than postulation and theory, I won't, as it goes contrary to other facts I assume to be true.
Now, I could believe it on a world-wide basis, but not on a gov't-by-gov't basis. I believe that economies will gravitate towards the more favorable environment, thereby increasing their share of world production (economic opportuity being a primary reason the US is the economic powerhouse it is) and increasing their value relative to other nations. I think that tax rate reductions help make the economy more favorable, and thereby will increase the gov't share of the world economy.
"No, I think I'll be campaigning for spending cuts so we can get the extra .7% growth and still have the option of deficit spending stimulus in the next cycle. 8*)"
I think I could buy into that!
Richard: So do you have some alternative theory? The theories I've quoted have reasonably good support, and even if they're not perfect, the fact is that nobody has come up with anything better. What are the "other facts" you assume to be true?
Regarding cutting spending and then cutting taxes again in the next cycle... do you realize that cuts to pay for the the current round still need to be found? As far as I know, nobody has identified enough spending cuts to make up for the current shortfall. If you tried to implement yet more cuts in the next cycle then you'd have to cut things like military spending, which Republicans seem rather fond of.
... Ami.
Richard,
“Now, I could believe it on a world-wide basis, but not on a gov't-by-gov't basis. I believe that economies will gravitate towards the more favorable environment,”
If I remember from reading the original report a while back (was it July?) There are actually some calculations for the influx of foreign capital.
Ami, as for some “other facts,” most conservative/libertarians think that the private market is more efficient than government at (some) functions. More efficient would imply more GNP output for less labor/capital inputs. I didn’t see any calculations for that.
In other words, if a $2 billion safety net feeding 200,000 people is cut, it might be replaced by charity. If charitable organizations feed those same people at a cost of $1 billion, there is a net gain to the economy of $1 billion. However, if, because of program cuts there are an additional 100,000 people who are out of work (replaced by volunteers), there may be no benefit. Or, if only 100,000 people are adequately fed, and crime (police costs) and starvation (emergency room costs) increase, it may also be of negative value (even if the cost per meal drops.)
I know chose an example that we may disagree on. How about one that we are more likely to agree on, like some vulgarity regulations? The MPAA does an ok job of rating the Movie industry, how about something similar for TV?
I would think there would be a wide variety of values for efficiency depending on what is privatized/eliminated these “other values” didn’t seem to be in the study.
That said…
The real problem I have with big government isn’t one of cost, but of Constitutionality. That harkens back to the old article you posted about Conservatives vs. liberals and “by the book-ness” vs. pragmatism.
And Ami,I really like the new layout.
Stryker:
"most conservative/libertarians think that the private market is more efficient than government at (some) functions. More efficient would imply more GNP output for less labor/capital inputs. I didn’t see any calculations for that."
"In other words, if a $2 billion safety net feeding 200,000 people is cut, it might be replaced by charity. If charitable organizations feed those same people at a cost of $1 billion, there is a net gain to the economy of $1 billion."
There's a flaw in your reasoning here. Charities aren't market driven. Efficiency in markets is due to the people who pay for goods trying to get the best deal for their money. As long as the people who consume the goods aren't the people who pay or who make decisions on what to buy (true with both governments and charity) the market mechanism doesn't come into play.
Libertarians favour charity on more idealogical grounds: they believe all transactions should be voluntary, and therefore oppose any form of taxation.
"The MPAA does an ok job of rating the Movie industry, how about something similar for TV?
I would think there would be a wide variety of values for efficiency depending on what is privatized/eliminated these 'other values' didn’t seem to be in the study."
I'm not sure what you mean here. I don't particularly like the movie ratings or T.V. censorship as they currently exist, and I don't, as a consumer, have a choice of other ratings systems in either media. I do believe that a more flexible system would benefit consumers, but how does the MPAA make things better?
Glad you like the new layout. It's not finished though - I just made some very small changes to a new template offered by Blogger. I haven't had time to customize it the way I would like.
"Richard: So do you have some alternative theory?"
I'm not an economist, but economies aren't just local anymore. Like I said, the theories you mention make sense on a world-wide basis, but the more competitive an economy becomes, the larger share of the world-wide economy it encompasses.
Example: Let's say the US economy encompasses 50% of world consumption (I don't know the actual figure). Let's also say that dropping the tax rates causes an influx of foreign consumption because US goods become cheaper. Now the US consumes 55% instead of 50%. The influx may or may not close the gap, but increased consumption exceeds the loss from inflation. In this case, a tax cut could create a tangible increase in the economy (not to mention tax revenues) through increasing their share in tne world economy.
Consider this for a moment. Any tax is an external inefficiency imposed on an economy. US taxes are myriad and complex, meaning that each tax creates a different inefficiency, and each inefficiency has its own impact. Reducuing some of them may increase gov't revenue, while others may cause a drop (this is one of the reasons I'm for the Fair Tax). Some level of taxation and inefficiency is required to run the gov't.
"Charities aren't market driven."
Sure they are, it's just configured differently than a traditional market. In charities, the product is their service, whatever it may be. The consumer is the donor to the charity. If the charity is too inefficient, or doesn't serve the needs of the donor to see whatever service done, they will either donate to a different charity or not donate at all.
Richard: I'm not sure I entirely follow what you're saying, but sure, taxes do have an effect accross borders.
But for every successful tax haven like Ireland, you have successful high-tax areas like Finland. For smaller economies, then, the question is where to position yourself. Do you want to be the country that companies operate because you're cheaper, or do you want to be the country that companies come to because the labour force is more productive. Do you want to compete on price, or on quality?
I don't think the choice really exists for larger economies like the U.S. The "high quality" or "low price" niches are too small. You need to be competitive in many areas, and that probably means finding a middle ground.
I agree that tax structure matters (as I've mentioned elsewhere). Most of my arguments are based on average taxes as a percentage of the economy. There's lots of room for improving the details of the tax system.
But none of these points challenges the basic principle that the rate of long-term growth is technology driven. If you could design the perfect tax system then you would certainly grow the economy, but once you'd implemented the system your growth would just return to the trend line.
I'm not suggesting that finding better tax structures is unimportant. If you can get 10% more production (an invented number) just by changing the tax structure then you should probably go for it.
Your point about charities is well taken. They are market driven if you consider the donor as the customer. But that makes the comparison with government meaningless. We don't normally measure the success of government programs by what the people who don't actually use the service think about it, yet this is what your "market" for charities does.
... Ami.
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