Did the Bush Tax Cuts Increase Economic Growth?

Paul Krugman answers a question about the Bush tax cuts in Money Talks: Economy No Longer Defying Gravity. The question is based upon his latest column:

Alan Gertler, Reno, Nev.: I'm a scientist, not an economist, so I'm fairly naive when it comes to what drives the economy. My question is this: Have the tax cuts stimulated the economy as claimed (which I don't believe given the past cases of Reagan and Bush senior), or has it been the willingness of the government to continue massive spending by increasing our debt that has led to the growth of the economy?

Paul Krugman: It's actually neither. About the Bush tax cuts: the tax cuts of 2001 evidently didn't do the job; these days, the Bush people talk about the economy as if history began in the middle of 2003, after their SECOND wave of tax cuts.

But while the economy did start growing, finally, in 2003, the growth wasn't at all of the form you'd expect if tax cuts were responsible. The main tax cuts were on dividends and capital gains; supposedly this would make it easier for businesses to raise funds and invest. But business investment hasn't been the main driver of growth; in fact, businesses have been sitting on huge piles of earnings, reluctant to invest. Instead, the big driver was housing construction and consumer spending.

So what really happened? Low interest rates led to a housing boom that eventually turned into a housing bubble. High house prices made people feel richer, and they could borrow against the increased value of their homes, feeding consumer spending. Tax cuts had nothing to do with it.

That's a good, and often overlooked point about business investment after the tax cuts.

Update: The legislation for the 2003 tax cuts was signed on May 28, 2003. The vertical line in the following graph showing real non-residential fixed investment goes through the data point for the third quarter of 2003 (data):

Comments

[spencer]

The way the dividend tax cut is suppose to make it easier for firms to raise capital and expand is through
improved profits expectations generating an increase in
the maket PE and thus lowering the cost of capital. But since the 2003 tax cut the S&P 500
has fallen some 20% to 25%.

So if the divdend tax cut was suppose to have lead to higher capital spendng and a stronger economy over the last few years it sure hasn't worked through the channels that most economist expect it to.

[pgl]

I'm not sure the data supports Paul on this one. I just compared 2006QI to 2003 QI. Overall real GDP rose by 12.3%. Consumption rose by only 11.2% and government purchases rose by only 5.8% (net exports fell). So investment demand overall rose by around 25% with the components being:

Residential: 26.7%
Business: 25.5%

If business investment rose by more than 25% over the past 3 years, how can Paul make this statement? Of course, I would argue that the rise in business investment was due in part to lower interest rates and due in part to just getting back to where we were before the investment led recession.

[spencer]

pgl --In the major econometric models business investment is driven by corporate profits. Given the increase in profits we have seen this cycle the rebound in capital spending is disappointing.

But it is like so many other things, what we are seeing is a fairly normal cyclical development and there is
little evidence that the tax cuts made a significant
difference.

Another point that relates to this is to break capital spending down into information technology and softwear vs all other, or traditional capital spending. If you look at real investment as a share of gdp what you find is that traditional capital spending is still about the same as it was in the late 1960s early 1970s. All the growth in capital spending since 1980 has been in the high tecdhnology sectors. If tax policy played a major role in the increase in capital spending shouln't it hav impacted all sectors. the fact that the growth has been contrated in one sector implies that the driving force are factors within that sector -- like falling prices -- rather then economy wide factors like taxes.

[pgl]

Spencer - exactly my point. If one only looked at investment spending since the 2003 tax law change (I see our host conveniently put up the chart in an update) and if one was silly enough to do the Post Hoc Ergo Propter Hoc nonsense they teach over at the economics department of National Review University, one might go "wow - the tax cut worked". But as you have so eloquently noted, one would have to look at a real model that would include various factors that would explain variaton in investment demand. If the other factors fully explain the increase, then the marginal impact of this tax law change is from modest to zero - at least per our model. Dr. Krugman's conclusion may be correct - but maybe he should have had you there to help him answer the question. Well done!

[anne]

No; there is not the least mystery over increased investment other than that it has not been far greater. We have been fighting a war, ostensibly several wars, domestic investment should have soared. The mystery is that investment in such amazingly profitable areas as energy has not been far greater. American business has had record or near record saving since shortly after the recession, and profits have been fine, but investment has been disappointing.

[anne]

"But business investment hasn't been the main driver of growth; in fact, businesses have been sitting on huge piles of earnings, reluctant to invest."

Precisely so, and I look to investment in portfolio allocation. American business have been reluctant to invest here given the superficial conditions. Investors have well noticed this, and Joseph Stiglitz has often spoken to this. Look to Sweden or Australia :)

[pgl]

I tried my hand at graphing the data over at Angrybear - and then pulled the excellent comment from Spenceer et al. Mark - thanks for starting a really interesting discussion!

[anne]

Imagine what the related domestic investment effect would have been had we taken the $10 billion a month for the needless tragedy of Iraq and used that in revenue sharing with the states for infrastructure development. We still pretend the war has been materially costless. Well, we seemingly would like to mask any of the more tragic costs but there has been a material cost that is not nearly done.

[bakho]

Doesn't the data track the monetary stimulus of low interest rates (with lag) closely?

[algernon]

When capital is highly taxed & you lower that rate of taxation, wouldn't you have to admit that in the long-run that should be of some benefit to the economy?

[Bruce Webb]

"When capital is highly taxed & you lower that rate of taxation, wouldn't you have to admit that in the long-run that should be of some benefit to the economy?"

Well no. Not absent some coherent argument to offset that. Give us some theoretical arguments backed by some historical numbers and then we will talk. But in essense you have given us a homework assignment without explaining why you are 'teacher' here. You are expressing an argument at such a high level of generality as to be useless. I'll engage this once you advance an argument that backfills the question of "how, where, when and why". That it seems obvious to you buys you nothing, do the hard work and present an argument.

Assuming that lowering the rate of taxation on capital represents "some benefit" is something for you to present a case and not something for me to defend against.

Bring your numbers. Present them with rigor. Demanding that I respond to your top level theorizing gets you nothing. Just because you were dazzled at your first exposure to Milton Friedman in Econ 101 doesn't mean we are similarly blinded.

Bring numbers. Otherwise I am admitting nothing.

[rana]

Why all the talk about investment? The Administration pushed through 4 tax cuts in four years, totaling some $200 billion per year, but the vast majority of the cuts have been on individual income taxes. The corporate patial expensing provsion--2002 to 2004--appears to have been a bust in terms of stimulating investment. All the growth investment can be explained by standard macro accelerator equations. (Note, profits ,in general do not help predict investment once lags of gdp growth are used in an equation.) Indeed, if it worked we would have seen a decline in investment in 2005Q1 when the temporary tax cut went off, particulaly for non-high-tech invesmtent (longer-lived assets with bigger tax savings). But it did not happen. The dividend tax cut has uncertain effects on investment, as a theoretical proposition--see Auerbach's "new view", for example. It certainly boosted dividend distributions, but probably not investement. The personal tax cuts--including the dividend cut--probably boosted consumption significantly. Private saving is now negative. The fall in the saving rate is probably attributable to the boom in housing and other wealth, but it is clear that the tax cuts were not saved. So yes, the rich do spend and they spent their tax cuts. The Administration's fiscal policies did stimulate aggregate demand, but since mid-2003 that has not been necessary, low interest rates would have revived the economy, albeit more slowly. There is no evidence of a supply side response--labor force participation has been unusually weak, the lower taxes did not spur private saving, and the partial expensing provision did not spur investment.

[anne]

When, by the way, was capital highly taxed in America :)

[Robert]

Spencer said:
The way the dividend tax cut is suppose to make it easier for firms to raise capital and expand is through improved profits expectations generating an increase in the maket PE and thus lowering the cost of capital. But since the 2003 tax cut the S&P 500 has fallen some 20% to 25%.

In 2002 & 2003, coincidental stock market earnings were cratered - especially across the S&P500 - but were also diminished across the rest of the market, for many and varied reasons, not least because 9/11, post-bubble hangover, lagged effects from raising of rates 2000 and the prevalence of massive write-offs during the year of malfeasance (Worldcom Enron, AOL, GlobalXing, Qwest etc.). Therefore the more useful valuation measure [of market PE] in evaluating the tax-cuts is "Price to Forward Expected Earnings" (an wtd. avg of one & two years out). And by these measures, the market looked (and indeed was!) extremely cheap (also confirmed by coincidental cash-flow measures or EV/EBITDA methods).

But that was 100% ago on the Russell small Midcap indices, and 60% or so on the large cap ones. Today, by contrast, representative indices (but more importantly equal-weighted indices of the "average stock") are at or near historic (2000) highs on all valuation measures (price to Fwd earnings, Prc-to-Cashfllow, EV/EBITDA. Though the large caps offer more attractive relative value, the entire opportuntity set has seen it's ratings dramatically elevated.

I am no fan of most of this admins tax cuts, though the elim of double taxation on dividends brings the US tax code into line with most other OECD nations, and while Krugman may be correct in pointing out that they did little for fixed investment, they DID succeed (or at least were coincidental to) [temporarily??] raising the forward PE (and other valuation measures on stocks).

Finally, the primary reason the PEs on the largest cap weighted indices (S&P500) appear cheap are the high current earnings on energy, commodity, financial, housing and cyclical issues. These are exerting a downward pull on aggregate cap-weighted valuation measures, though there appears to be reluctance by he market to "believe" these earnings are sustainable going forward in an environment where CA deficits become more difficult to fund, housing slows, and fiscal deficiencies must be addressed through higher taxes, lower expenditure, or the most irresponsible outcome, simply printing money let the chips fall where they may...

[anne]

"The way the dividend tax cut is supposed to make it easier for firms to raise capital and expand is through
improved profits expectations generating an increase in
the maket PE and thus lowering the cost of capital. But since the 2003 tax cut the S&P 500 has fallen some 20% to 25%."

There has to be a mixing of thoughts here. Since October 2002, America has been part of an international bull markets in stocks. While the American market has lagged international markets, we are nonetheless part of the international bull market. What are we missing in the passage?

[anne]

Whether the international bull stock market falters or continues from here, this has been one of the deepest and broadest bull markets I can find. Add in the somewhat overlapping international bull markets in real estate and bonds, and the period has been astonishing in building wealth for diversified patient investors in country on country.

[anne]

The 3 year return for the S&P stock index through April 30, was 14.5% a year which is excellent though in this soaring bull market lags international returns. The total American stock market return was better than that for the S&P. The Europe index return has been a quite remarkable 27.4% a year through this period. What continually surprises me is how seemingly little attention has been given to this international bull market.

[spencer]

the US large cap market, what I work on, has experienced about the smallest increase of any of the world stock markets. Moreover, the rise in the S&P 500 and been driven completely by earnings growth as the Pe on that market has actually fallen.

But I will stand corrected. the S&P 500 pe on trailing operating earnings did rise from about 18 to 20 in early 2003 when the tax code was changed, but it has since given up that bounce.

[anne]

Agreed completely, and now I understand that what was referred to were the changes in the price earning ratio for the S&P which I should have understood. An important finding and worth clarifying :) I will think carefully about this.

[anne]

Spencer, then, is telling us that the supposed tax inducments to spur investment did not raise the price earning ratio for the S&P, which might have been expected. This is quite an interesting finding that I otherwise would not have thought important. Well done :)

[Frank]

Not an economist here, but THANK YOU BRUCE WEBB FOR DEMANDING RIGOR. If only the media and the American public were half as exigent of those presenting half-baked ideological theories and rhetoric.

[algernon]

If you said that a society characterized by secure property rights would be more prosperous than the opposite (eg, the old Soviet Union), I guess Bruce Webb would say "give me theoretical arguments backed by some historical numbers" or shut up.

[anne]

Algernon, nice comment :)

Actually the question of how much secured property rights can increase or decrease economic well being is quite important to look to closely. A prime need in emerging economies is to widen and secure property rights, but how and at what cost is this to be done? What of current owners, what of current lack of ownership? Think of China or Bolivia or Zimbabwe or South Africa.

[anne]

With so immense a store of intellectual property, secured intellectual property rights in developed economies, how is technology transfer to occur? Absent technology transfer and China does not develop significantly. Brazilian and South African leaders understand, Mexican leaders appear not to understand.

[Robert]

Anne said:

Whether the international bull stock market falters or continues from here, this has been one of the deepest and broadest bull markets I can find. Add in the somewhat overlapping international bull markets in real estate and bonds, and the period has been astonishing in building wealth for diversified patient investors in country on country.

The deepest broadest bull market has been in liquidity itself. The assets markets (stocks glbally, real estate, and virtually every other measured vs. paper) are reflective of this growth in liquidty in marked in excess over that implied by economic growth in GDP.

I apoligize for beating this one, but would suggest again that the valuation bump in trailing operating earnings (which Spencer highlighted) still doesn't reflect that fact the average listed company (whether measured by the median) in the USA has seen dramatic valuation re-ratings. The relaltive underperformance of the large cap issues also has been an international phenomena (due I believe to the proliferation of ETFs & other cap composite assets as hedge vehicles). If you adjust for this structural "style anomaly" in markets, the rise in the stock market rating coincidental to the Tax cuts has been meanigful and large. While I personally believe this is only a coincidence and not reflective of the desired transmission mechanism (since I believe it's driver is liquidity in general that's raised the rating), I do believe one cannot honestly use this as ammunition to diss the tax cuts (uncomfortable as it is to sit on that side of the fence if only foir a few minutes).

[RP]

There may have been investment, but from my perch a lot of the investment was redirected outside the US by how MNCs have invested. We continue adding to the global engineering team (US but also significantly more globally as one would expect) at a relative-to-the-US cheap price, we get more productivity, invest less overall to get the same number of engineers, increase US GDP to the degree our globally engineered products result in US-homed company profits. I don't see anything inconsistent here....except for the part about the Fed/Treasury thinking it can control which economy it inflates....in a globalized world, the inflating goes where the pressure is lowest..

[anne]

Actually the perception does not resolve the problem. American corporate saving has been at or near record levels from shortly after the recession ended in November 2001. American corporate invesment, wherever located has been relatively less that would be expected from past recoveries and past fine earnings. Also, while Federal Reserve policy has an international effect, the Fed can control inflation in our economy though where borrowed money is invested may be another matter.

[spencer]

Robert -- good points . In my Pe equations the jump in the S&P 500 PE in 2003 was within one standard error of the estimate. I use plus or minus one standard error to create a fair value band rather then a point estimate. So I far as I know it was just random noise or it could have been the impact of the tax.

I do not want to knock the tax, it is rational and may actually be good policy.

I just want to knock those who are claiming that all good thing that happen is because of the Bush tax policies.

[anne]

That the price earning ratio for the S&P stock index has fallen over the last 3 years even though the index has returned 14.5% a year through April 30, shows how strong earnings have been. That a 14.5% return should lag all international developed country stock markets with no currency effect to speak of, shows both how much value there was in international stocks and how powerful a bull market this has been. Again, I could not be more impressed.

[anne]

American investors with diversified portfolios, especially those who noticed the relative valuations of international stocks several years ago in both developed and emerging markets and diversify internationally have been most fortunate. International investors have gained as well, and added gains in real estate and bonds as American investors have.

[algernon]

Anne,
As the world-wide liquidity-fed inflation in assets & commodities "trickles down" into consumer goods, your financial assets will not fair so well.

[anne]

Algernon:

"As the world-wide liquidity-fed inflation in assets & commodities "trickles down" into consumer goods, your financial assets will not fair so well."

Forgive me, but there is a critical investing error that is all too often found. Not only have investors with diversified index portfolios been part of a superb bull market since October 2002, but they have been part of a bull market for the last decade and last 2 and 3 decades. The warning that a time will come when all the gains will be gone because of inflation is both something that would have cost investors decades of gains but would make it impossible for an investor to intelligently protect a portfolio against inflation.

[anne]

Investors in the Vanguard S&P stock index have earned 12.2% a year for 30 years. The Vanguard long term invest-grade bond fund has earned 8.7% a year over the last 33 years, inflation nonetheless. There are the value index, Europe index, the real estate investment trust index, health care and energy funds, bond indexes from short to long. No matter how cautious an investor wishes to be, there is a ready fair cost portfolio to be constructed.

[anne]

Robert:

"The deepest broadest bull market has been in liquidity itself. The assets markets (stocks glbally, real estate, and virtually every other measured vs. paper) are reflective of this growth in liquidty in marked in excess over that implied by economic growth in GDP."

Then, think through a Vanguard portfolio that will be highly cautious but protect both against a continuing of the last 30 years of fine investment and another fierce bear market. Where the real danger resides is in not investing, and Vanguard has for 33 years given savers and investors ways of matching fine professional investors while allowing for safer and more diversified portfolio development through time.

[anne]

The protection against inflation, which I do not fear, is sensible investment. A combination of domestic and international stock and real estate index funds and domestic fixed duration bond funds will protect any investor. The real danger is in not investing. I emphasize Vanguard investing, because there is simply no company that offers such rewarding and efficient opportunities for portfolio construction.

[Robert]

Anne you are wise, let it be said. And the accolades that you afford Vanguard are deserving since as far as agent investment managers go, they do provide what appears to be an honest service at an honest price (unlike Fidelity and other closet indexers charging active management fees.

And I agree that typically investing is indeed better than not investing - be this a 100% stock portfolio or a 100% bond portfolio at the extremes. But just as you implore people to invest, I implore them to understand that never in the post-depression period has the penalty function for wrongly-placed allocation been so dramatic. This is a result of unprecedented global liquidity growth, its impact investment, broad international economic activity, and particularly upon asset prices. Watching yesterday's equity index returns, is really of little help in trying to avoid getting stuck with Keynes' proverbial old maid, in the next round. My extension of this analogy is that there are now four old maids in the deck, and so the probability of getting stuck with her has increased dramatically as result of mis-guided fiscal policies in the US, and monetary policies in the US and Japan.

[anne]

Same to you :)

Suppose then that we are especially worried about too much international liquidity causing either significant inflation or more likely a severe enough Federal Reserve high short term interest rate policy to cause a recession. What then; what sort of portfolio might suffice?

A Vanguard intermediate term bond fund will have a duration of about 5 years, which means that at a current interest rate of 5.5% an investor will have more than $5,500 income a year for 5 years for each $100,000 invested through the most severe economic adjustment and be well positioned with no portfolio at the end of the period no matter what interest rates happen to be.

Take then another $100,000 and buy the value index with a 2.4% dividend, and the income is another $2,400 while the investor hopes for an end to a severe market and capital gains. The REIT index would give a 3.4% yearly dividend. Eventually there will be a recovery, eventually owning 300 of the most prominant value category businesses in America will bring capital gain.

Where then is the long term danger is a 50% bond and 50% stock fund portfolio, provided there have been enough past savings to gain a reasonable income while waiting for capital gain?

[anne]

So, a 2 fund portfolio that is highly conservative, highly diversified come what may. From there an investor can become fancier, more or less conservative, more diversified, but sharing in what will in time be gains in the economy and markets even if gains are quite delayed.

[cm]

algernon: Well, perhaps you would not be asked to present evidence for your property thesis, but you should be prepared to.

Actually one can well make the case that economic/social stagnation and decline in "communist" societies was not primarily caused by lack of property rights, but broad disengagament because of being denied effective participation in deciding what to do best with the resources (which is of course not completely independent from property rights).

Similar tendencies can be observed in the West, e.g. corporations but also municipalities. Locking stakeholders out of the decision and governance process, or merely the perception thereof, leads to disengagement, disloyalty, withdrawal, and selfishness, and at the very best fragmentation into small ad hoc subcultures (the small-scale private domain being where "participation" cannot be taken away).

Most individuals being "by nature" complacent and inclined to go the path of least resistance, participation usually need not even be denied actively, but merely not encouraged.

[anne]

We passed through the toughest bear market in stocks since the Depression in the last decade but notice these decade long returns:

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
4/28/95 to 4/28/06

S&P Index is 8.9
Large Cap Growth Index is 8.2
Large Cap Value Index is 9.5

Mid Cap Index is 14.7

Small Cap Index is 10.3
Small Cap Value Index is 13.4

Europe Index is 10.7
Pacific Index is 1.3
Emerging Markets Index is 8.6

Energy is 11.3
Health Care is 16.5
Precious Metals is 12.0
REIT Index is 15.3

High Yield Corporate Bond Fund is 6.2
Long Term Corporate Bond Fund is 7.2

[anne]

Read my lips :)

http://www.nytimes.com/2006/05/21/washington/21tax.html?ex=1305864000&en=7c84696f1594960a&ei=5090&partner=rssuserland&emc=rss

May 21, 2006

Despite Pledge, Taxes Increase for Teenagers
By DAVID CAY JOHNSTON

The $69 billion tax cut bill that President Bush signed this week tripled tax rates for teenagers with college savings funds, despite Mr. Bush's 1999 pledge to veto any tax increase.

Under the new law, teenagers age 14 to 17 with investment income will now be taxed at the same rate as their parents, not at their own rates. Long-term capital gains and dividends that had been taxed at 5 percent will now be taxed at 15 percent. Interest that had been taxed at 10 percent will now be taxed at as much as 35 percent.

The increases, which are retroactive to the first day of the year, are expected to generate nearly $2.2 billion over 10 years, according to the Congressional Joint Committee on Taxation, which issues the official estimates.

Over all, the tax bill that Mr. Bush signed Wednesday reduces taxes by $69 billion.

Mr. Bush pledged in 1999 to veto any bill that raised taxes. In response to a question about the tax increase on teenagers in the new legislation, the White House issued a statement Friday that made no reference to the tax increase, but recounted the tax cuts the administration has sponsored and stated that President Bush had "reduced taxes on all people who pay income taxes."

Challenged on that point, the White House modified its statement 21 minutes later to say that Mr. Bush had "reduced taxes on virtually all people who pay income taxes."

The deputy White House press secretary, Kenneth A. Lisaius, declined to discuss the reasons Mr. Bush broke his pledge or anything else beyond the modified statement, which emphasized the $880 billion in tax reductions from tax laws Mr. Bush signed in 2001 and 2003.

Americans for Tax Reform, an influential lobbying group that seeks to reduce taxes, had led the drive to press politicians to pledge no new taxes. The pledge has been signed by 256 members of the House and the Senate, nearly all of them Republicans, and by thousands of candidates for state and local office.

The pledge commits signers to "oppose any and all efforts to increase the marginal tax rates for individuals and businesses." Mr. Bush went beyond the pledge when he was seeking the Republican nomination for president.

"If elected president, I will oppose and veto any increase in individual or corporate marginal income tax rates or individual or corporate income tax hikes," he wrote in June 1999 to Grover Norquist, president of the Americans for Tax Reform....