Tax Cuts and Changes in Output

One more time, tax cuts do not pay for themselves:

Tax Cuts May Come At a Price, Study Says Treasury: Financing Must Be Found, by Nell Henderson, Washington Post: The federal government will need to either cut spending or raise taxes down the road to pay for extending President Bush's recent tax cuts, the Treasury Department said in a report released yesterday, dismissing the idea popular with many Republicans that such sacrifices can be avoided.

The ... Treasury's view reflects "a recognition the federal government has to finance the tax relief" to avoid a rise in government debt, Robert Carroll, deputy assistant secretary for tax analysis, said in an interview.

The report stressed that the economic effects of extending the tax cuts "depend crucially on whether they are financed by lower spending or higher taxes in the future." ...

If ... tax cuts are extended and matched by comparable reductions in government spending, under the best scenario, the nation's level of economic activity would be increased by about 0.7 percent per year over time, or by $90 billion a year in current dollars, Carroll said.

If the government instead decides to raise taxes later, effectively making the tax cuts temporary, that could lower economic output over time, the report said. ...

The Treasury report released yesterday relieved "a lot of fears that dynamic scoring would lead to the view that cutting taxes raises revenue," said Jason Furman... Rather, the report "pours a huge bucket of cold water on the exaggerated claims that tax cuts transform the economy and pay for themselves." ...

Here's commentary from the WSJ on the same topic posted on Greg Mankiw's blog:

Dynamic Analysis by Robert Carroll and N. Gregory Mankiw, Commentary, WSJ: Does tax relief mean more economic growth? Many people believe the answer is yes, and now they get strong support from the staff of the U.S. Treasury.

Most press reports on the Mid-Session Review of the federal budget, released by the Bush administration a couple of weeks ago, focused on the good news about expanding tax revenues and the shrinking budget deficit. But for tax-policy geeks, the most intriguing part of the report was an easily overlooked box on page 3: "A Dynamic Analysis of Permanent Extension of the President's Tax Relief." Over the past six months, the Treasury Department staff has been studying the dynamic effects of tax cuts on the economy. The results of this analysis, previewed in this box, were released yesterday in more complete form (available at http://www.treas.gov/offices/tax-policy/).

A bit of background: Most official analysis of tax policy is based on what economists call "static assumptions." While many microeconomic behavioral responses are included, the future path of macroeconomic variables such as the capital stock and GNP are assumed to stay the same, regardless of tax policy. This approach is not realistic, but it has been the tradition in tax analysis mainly because it is simple and convenient.

In his 2007 budget, President Bush directed the Treasury staff to develop a dynamic analysis of tax policy, and we are now reaping the fruits of those efforts. The staff uses a model that does not consider the short-run effects of tax policy on the business cycle, but instead focuses on its longer run effects on economic growth through the incentives to work, save and invest, and to allocate capital among competing uses.

The Treasury report describes what will happen to the economy if the tax relief of the past few years is made permanent, compared to the alternative scenario of reverting back to the tax code as it was in 2000. Specifically, the report analyzes the effects of lower taxes on dividends and capital gains, the effects of lower taxes on ordinary income, and the extension of other tax cuts, including the new 10% bracket, the expanded child credit and marriage-penalty relief. Here are three main lessons.

Lesson No. 1: Lower tax rates lead to a more prosperous economy.

According to the Treasury analysis, a permanent extension of the recent tax cuts leads to a long-run increase in the capital stock of 2.3%, and a long-run increase in GNP of 0.7%. In today's economy, such a GNP expansion would mean an extra $90 billion a year that the nation can spend on consumer goods to raise living standards, or capital goods to maintain prosperity. More than two-thirds of this expansion occurs within 10 years.

Lesson No 2: Not all taxes are created equal for purposes of promoting growth.

Some tax rate reductions have a profound impact on incentives and economic growth, while others have minimal or even adverse effects. The Treasury staff reports particularly large bang-for-the-buck from the reductions in dividends and capital-gains taxes. Even though these tax cuts account for less than 20% of the static revenue loss from permanent tax relief, they produce more than half of the long-run growth.

At the opposite end of the spectrum are the tax reductions from the 10% bracket, child credit and marriage-penalty relief. These tax cuts put money in people's pockets when, during the recent recession, the economy needed a short-run boost to aggregate demand. They also fulfill other objectives, such as making the tax system more progressive. But they illustrate that not all tax cuts promote long-run growth. Treasury estimates that without the tax reductions from the 10% bracket, child credit and marriage-penalty relief, the long-run increase in GNP would be larger -- 1.1% rather than 0.7%.

Lesson No 3: How tax relief is financed is crucial for its economic impact.

Like all of us, the government eventually has to pay its bills. In technical terms, the government faces an intertemporal budget constraint that ties the present value of government spending to the present value of tax revenue. This means that when taxes are cut, other offsetting adjustments are required to make the numbers add up.

The Treasury's main analysis assumes that lower tax revenue will over time be accompanied by reduced spending on government consumption. But the report also shows what happens if spending cuts are not forthcoming. In this alternative scenario, a permanent extension of recent tax relief is assumed to lead to an eventual increase in income taxes.

The results are strikingly different. Instead of increasing by 0.7% in the long run, GNP now falls by 0.9%. Tax relief is good for growth, but only if the tax reductions are financed by spending restraint. One exception: Lower taxes on dividends and capital gains promote growth, even if they require higher income taxes.

These Treasury results are sure to spark debate and further research. While the Treasury report is not the last word on dynamic analysis, it is a big step toward a more realistic view of tax policy.

This says that cutting taxes knowing that you will have to raise them again in the future is unwise because it will result in a lower level of output.

I want to point out that Lesson 1 summarizes the effect of the policy on the level of output, a movement to a new steady state. It is not a change in economic growth. A one-shot increase in the capital stock of 2.3% increases the level of output, in this case by .7% if (infeasible) cuts in spending are used to cover the tax cuts, but there is no change at all in the growth rate of output. Quoting from the report, "In the steady state, per-capita growth in the model is equal to a constant rate of technological change." I've missed something somewhere. The commentary is about changes in economic growth, not changes in the level of output, so it would be helpful to see the connection between tax cuts and the (constant) rate of technological change explained further since an increase in the rate of technological change is needed to increase the growth rate of per capita output.

Finally, the acknowledgement that this is not that last word, and that further research is needed, says not to take the actual numbers the model produces too seriously -- they are subject to a great deal of uncertainty.

Update: Menzie Chinn at econbrowser also comments on the Treasury report.

Update: David Altig at macroblog follows up with "A Teachable Moment."

Comments

[Winslow R.]

" The commentary is about changes in economic growth, not changes in the level of output, so it would be nice to see the connection between tax cuts and the (constant) rate of technological change explained further since an increase in the rate of technological change is needed to increase the growth rate of output. "

I think it's obvious that the explanation would not justify cutting the estate tax etc. so why would they bother?

I don't understand why Democratic presidents have taken the 'simple and convenient' way out on dynamic budget analysis and allowed Bush to take the (mis)lead? What are the best ways to spend government money to optimize output? The people decide when money needs to be spent, it could be useful if mainstream economists had a better answer than 'the capital stock and GNP are assumed to stay the same, regardless of tax policy.'

[ilsm]

The tax cuts have resulted in round about crowding out.

The fed supported the fiscal insanity while the Chinese supported the dollar.

The result: instead of investing in US productivity US consumption supported outsourcing the growth in real productivity.

The tax cuts did nothing beyond buying Bush's reelection.

[spencer]

Cuts in the tax rates on dividends and capital gains are suppose to work through a rise in the stock market PE that reduces the cost of capital and so encourages capital spending.

But the stock market PE has been falling for the last 5 years. So until we see a rise in the PE not due to falling rates and/or inflation the tax cuts on dividends and/or capital gains can not have any impact
and they clearly have played no role in the current cyclical rebound in capital spending.

P.S. the current rebound in nonresidential fixed investment is the weakest in any cycle since the depression. It is now up 21% from the economic bottom versus 40% at the same point in the 1990s and 50% in the 1960s.

[bakho]

This is a part that I don't get:

"Treasury estimates that without the tax reductions from the 10% bracket, child credit and marriage-penalty relief, the long-run increase in GNP would be larger -- 1.1% rather than 0.7%."

I thought that during a slack demand recession, more money in the pockets of the poor was stimulatory. Why should cutting taxes on the poor decrease GNP? Does anyone know how they arrive at that conclusion?

[Bruce Webb]

This is incoherent. Start with the Treasury wordage:

"If ... tax cuts are extended and matched by comparable reductions in government spending, under the best scenario, the nation's level of economic activity would be increased by about 0.7 percent per year over time, or by $90 billion a year in current dollars, Carroll said."

End up with Mankiw:

"According to the Treasury analysis, a permanent extension of the recent tax cuts leads to a long-run increase in the capital stock of 2.3%, and a long-run increase in GNP of 0.7%. In today's economy, such a GNP expansion would mean an extra $90 billion a year that the nation can spend on consumer goods to raise living standards, or capital goods to maintain prosperity. More than two-thirds of this expansion occurs within 10 years."

Sorry Mankiw "the nation" doesn't get to spend that $90,000,000,000, the people who get the tax cuts do. Moroever he just discounts to zero the social utility of that foregone government spending in theh process.

There was a time and a place when it was simply assumed that you would get a better deal on electricity and water is you just diverted the actual cash flow through Enron and Vivendi. The notion that the economic friction of greed might in someway more than offset the doubtful efficiencies of private over public management were just waved away.

You want to introduce dynamic scoring? Well apply it to everything. How much ultimate tax revenue at all levels is generated by $100,000,000,000 in federal spending on highways? We capture up to 40% of the amount spent on labor in the form of income and FICA taxes, local economies collect a bundle on sales tax on the raw products going into the highway and overpasses, everybody concerned is busily spending their paychecks hence pouring more money into government coffers in the forms of sales and property tax, you get multiplier effects all around. But do you think supply siders would ever think to dynamically score the cost of the Transportation and Public Safety Act of 2009? Not on your life. Government spending is treated like it was money dropped into the grave while giving the same amount of money back to wealthy tax payers is treatied as the elixir of life for the economy.

Well Keynes may be technically dead but his ideas live on. An injection of money into the economy will have an effect and pretending that that effect will have an extra infusion of fairy dust because it is diverted through Ken Lay's magical pocket is something that needs to be demonstrated and not asserted.

I am not going to try to pick through the details but I have to say that that $90,000,000,000 is curiously unanchored by any estimate of the foregone spending or the lost revenue. But it would seem that the Free Lunch sign is always lit chez Supply Side Cafe.

[Holly W.]

I'll have to read this through whole article, but at the moment the phrasing "Tax Cuts May Come at a Price" has got me ROFL. With bitter humor, mind you ...

[Movie Guy]

Greg Mankiw and Robert Carroll - "In his 2007 budget, President Bush directed the Treasury staff to develop a dynamic analysis of tax policy, and we are now reaping the fruits of those efforts. The staff uses a model that does not consider the short-run effects of tax policy on the business cycle, but instead focuses on its longer run effects on economic growth through the incentives to work, save and invest, and to allocate capital among competing uses."

I want to know about this meeting, Greg.

What did he really say? Come on, you can tell us.

[nyuk]

How can any serious economist take the Treasury study, or anything Greg Mankiw says, with less than a full box of salt?

Read my lips: the government is running massive structural deficits. It is simply ludicrous to believe that we will grow our way out of it. It is equally ludicrous to believe we can spending-cut our way out of it. The mainstream among us need to ignore the idealists who think they can "dismantle the welfare state" and that will solve the problems. Too many people, including many of those idealists, will at some time, need that welfare state. So let the Milton Friedman's gripe, ignore them, and let's get on with the business of making practical and realistic changes in tax policy. Sooner or later, the population will demand some populism.

[johnchx]

bahko wrote: "I thought that during a slack demand recession, more money in the pockets of the poor was stimulatory. Why should cutting taxes on the poor decrease GNP? Does anyone know how they arrive at that conclusion?"

By ignoring the short-run counter-cyclical effect completely. That what the WSJ commentary means by:

"The staff uses a model that does not consider the short-run effects of tax policy on the business cycle, but instead focuses on its longer run effects on economic growth through the incentives to work, save and invest, and to allocate capital among competing uses."

[Bruce Webb]

"Read my lips: the government is running massive structural deficits. It is simply ludicrous to believe that we will grow our way out of it. It is equally ludicrous to believe we can spending-cut our way out of it."

Oddly enough people were making that same precise argument in 1992. At the time it was termed "deficits as far as the eye can see". And they had a perfectly valid point, absent a sustained set of economic performances well above the historical trend those structural deficits were effectively permanent.

Only thing was we proceeded to string together a series of economic performances well above the historical trend and by 2000 had put the General Fund in surplus, an outcome that would have been rejected as totally impossible eight years before.

Those who want to make the claim that "we cannot grow out of this" need to put some numbers on the table. What is your implied rate of economic growth? What would happen if you place a slightly higher series in their place? While some people may not believe we can sustain the same rate of economic growth over the next ten years that we did over the last, there is no reason a priori that I should accept that conclusion.

Because there is a rate of economic growth would allow us to grow out of this. I couldn't tell you what that rate is, but it exists. Mathematically it kind of has to. Now the working assumption is that whatever that theoretical rate is we can't reach it. Well that would be a lot clearer if someone actually put that number on the table and let us compare it to past performance.

But that will never happen because it doesn't suit either side's policy interest. The Right has a vested interest in their "drown the baby" strategy for domestic spending but their only proven selling point for that strategy is "we can't afford it". And while parts of the Left are perfectly willing to restore some progressivity to the tax system, and include me in, explaining why progressive taxation is not redistribution is hard, claiming we can't afford Bush tax cuts is easy. But it all depends on your assumed rate of growth.

I put up a post on this in April 2005 Productivity: 2006 Budge vs Trustees 2005 Report as an answer to my self-posed question "How do the President's men predict productivity when they are talking tax cuts?" And to quote directly from the Analytical Perspectives of the Budget we find this interesting answer (p. 191):

"Trend productivity growth is assumed, conservatively,
to be 2.6 percent per year. That pace is noticeably below
the average since the business cycle peak in the first
quarter of 2001 (4.2 percent per year). It is, however,
close to the pace during 1996–2000 (2.5 percent) and
not far from the average since the official productivity
series began in 1947 (2.3 percent)."

The key word of course is conservatively. At a time when they are trying to sell the magic of tax cuts why would they be low balling the productivity number in the Budget? Well I think I know the answer to that, but in any event lowballing it they are. What happens if you just substitute 3% for 2.6%? Or 3.3%? Given recent economic performance neither seems out of line and certainly either would massively move revenue projections. How much? I don't know. But some of you could probably figure that out. Be my guest.

[bakho]

Growing our way out of it will not happen because the Fed would never allow our economy to expand at that rate. Of course, if it expands too fast, there will be inflation and we would inflate away the debt.

[Bruce Webb]

And if you take up that invitation you might want some updated numbers. The economic discussion starts on p. 165 of the Analytical Perspectives of the 2007 Budget (not much difference from the 2006):

http://www.whitehouse.gov/omb/budget/fy2007/pdf/spec.pdf

And who would want to be without a copy of the 2006 Trustees' Report? No one I know: http://www.ssa.gov/OACT/TR/TR06/index.html

Don't forget to compare the productivity numbers. If you can explain why the two official government models diverge so much don't hestitate to write. And bonus points if you can explain why growth is going to drop back towards trend. I mean it could, but they never explain why they believe it will.

I am not sure any discussion of the sustainability of tax cuts is profitable given what appear to me pessimistic growth estimates. Sheesh even the Bush guy's come out and call them "conservative". Try "realistic" or even at a stretch "optimistic" ones instead. At least for the sake of argument.

[bakho]

Thanks for the clarification Johnchx.

I still don't understand why tax cuts to the poor would decrease GNP. Since the poor spend all their money, tax cuts for the poor will be captured by business. The model must be leaving something out in addition to the short run countercylical effect.

[johnchx]

Bruce Webb wrote: "Because there is a rate of economic growth would allow us to grow out of this. I couldn't tell you what that rate is, but it exists."

Well, a GDP growth rate, on its own, doesn't tell us enough. We need to nail down two other variables at the same time: (a) the ratio between GDP and tax revenues, and (b) the ratio between GDP and total outlays.

If (a) and (b) are constant over time, then there really is no way to "grow" our way to a balanced budget. That is, if a 5% increase in GDP yields a 5% increase in revenues and a 5% increase in outlays, then we're no better off than we started.

So the key to growing our way to balance is either (a) growing the ratio of tax revenue to GDP or (b) reducing the ratio of outlays to GDP (or both, of course).

There's some evidence that the increasing concentration of income, combined with the modestly progressive income tax rates, is in fact raising the revenue-to-GDP ratio. Spending as a share of GDP, however, is also likely to grow rather than shrink (Medicare being the major driver, of course).

Historically, outlays have held pretty steady at around 20% of GDP.

[Bruce Webb]

bakho, but what IS that rate? And what if we were ALREADY growing faster than that? The Bush budget projects growth at 3.0% plus through 2008, what happens if we just continue at that rate?

The assumed slowdown to average 2.6% is underdetermined in this model. The only reason I can think for keeping it so far below the trend of the last six years is to keep the sharp divergence between the productivity tables from being too stark. I mean on the one hand when the Secretary of Treasury has his Trustees hat on he pegs longterm productivity at 1.7%, it is already pretty puzzling why that jumps to 2.6% with his Budget hat on. I can understand why they can't report a trend number any higher, but there is no doubt it distorts the numbers.

Look once someone figures that theoretical rate at which we can finance the budget we can talk about whether the Fed would allow it to happen. But for the life of me I cannot see a single thing about shrinking debt payments as a percentage of GNP that would in and of itself represent some kind of threat drawing Fed action, if anything it should be a benign development.

My personal view is that SSA's Intermediate Cost model is distorting everything. Preserving 'crisis' in Social Security is causing the Budget folk to use more conservative numbers than they might like, which in turn is distorting projections for revenues going forwards. Once we finally move on from Social Security and stick some real numbers into the front ends of these models we may get somewhere.

[nyuk]

I can't put the numbers you want on the table anymore than a person who would claim that we CAN outgrow the deficit. But simple logic suggests that growing the economy, i.e., increases in GDP, won't do anything for the federal budget if the federal government doesn't tax an adequate portion of the GDP.

I'll tell you what numbers I can offer, though. I was looking at census income data, which shows that in 2003, there were 112,000 households, and that the lower limit of the top 5% of households received income of $154,120. For the sake of discussion, I assumed that 95% of the 112,000 households (106,400) had all earned that $154,120 - an ABUNDANTLY generous overestimation of ridiculous proportions. Doing so only yields $16.4 billion in INCOME to tax from the bottom 95% of households in 2003. Clearly, we cannot rely on 95% of households to provide any significant revenue toward the federal budget. At the current rate of taxation of everyone other than the bottom 95% of households, the federal budget runs a significant deficit. I suppose if all the economic growth goes to everyone other than the bottom 95% of households, which certainly seems within the realm of possibility, we can outgrow the deficit if the growth is high enough. But I can't even begin to imagine how high that will need to be.

I've admitted before that I'm not an economist. And I welcome kind critiques of my logic and methods. Thanks for taking the time to consider my comments.

[johnchx]

bakho wrote: "I still don't understand why tax cuts to the poor would decrease GNP."

Since the tax cuts aren't matched with spending cuts, they add to the deficit and crowd out private investment. Less investment means less capital, which in turn means less productivity, therefore less income. (Keep in mind that they're talking abou the long-run impact on GDP, not the immediate change, which is approximately a wash, with an increase in consumption balanced by an equal reduction in investment.)

[johnchx]

nyuk wrote: "I was looking at census income data, which shows that in 2003, there were 112,000 households..."

There are around 112 *million* households in the U.S. It looks like the figure you're quoting was expressed in thousands.

So, adjusting your calculation (which is, as you say, a significant overestimate) you get $16.4 *trillion* in income in the lower 95%.

[nyuk]

Wow. That was a big mistake on my part. Thanks for pointing that out.

[Blisex]

«I still don't understand why tax cuts to the poor would decrease GNP.»

The short answer is: because that is a predetermined conclusion.

The papers mentioned use a very narrow and peculiar (to say the least) set of assumptions, and the conclusions hold only under those assumptions, but the numbers are being presented as if they were generally valid conclusions.

Without knowing exactly what elasticities the model contains it is hard to guess, but odds are that the model is designed so that extra low end income is wasted in non productive activities like health care, and high end income is invested in productivity enhancing infrastructure. If also one can assume that higher after-tax low end incomes would lead to an increase in imports of cheap chinese goods, and higher after-tax high end incomes instead to investment in the USA, then it looks even better.

Anyhow, all conclusions of the study are totally meaningless, as the effects not only depend on strange assumptions, but are too small to take seriously either way, considering the margins of error such estimates have.

also note a very important point: such studies involve only the income tax, which is just about the only progressive part of the tax system.

Studies on lowering sales taxes or payroll taxes, which are heavily regressive, tend to be rather scarcer, because of course the taxes to cut are the federal income and estate ones, because it is those that depress the ''trickle down'' effect.

[Blissex]

«I still don't understand why tax cuts to the poor would decrease GNP.»

The short answer is: because that is a predetermined conclusion.

The papers mentioned use a very narrow and peculiar (to say the least) set of assumptions, and the conclusions hold only under those assumptions, but the numbers are being presented as if they were generally valid conclusions.

Without knowing exactly what elasticities the model contains it is hard to guess, but odds are that the model is designed so that extra low end income is wasted in non productive activities like health care, and high end income is invested in productivity enhancing infrastructure. If also one can assume that higher after-tax low end incomes would lead to an increase in imports of cheap chinese goods, and higher after-tax high end incomes instead to investment in the USA, then it looks even better.

Anyhow, all conclusions of the study are totally meaningless, as the effects not only depend on strange assumptions, but are too small to take seriously either way, considering the margins of error such estimates have.

also note a very important point: such studies involve only the income tax, which is just about the only progressive part of the tax system.

Studies on lowering sales taxes or payroll taxes, which are heavily regressive, tend to be rather scarcer, because of course the taxes to cut are the federal income and estate ones, because it is those that depress the ''trickle down'' effect.

[Winslow R.]

Johnchx wrote:

"Since the tax cuts aren't matched with spending cuts, they add to the deficit and crowd out private investment. Less investment means less capital, which in turn means less productivity, therefore less income. (Keep in mind that they're talking abou the long-run impact on GDP, not the immediate change, which is approximately a wash, with an increase in consumption balanced by an equal reduction in investment.)"

As you have pointed out in the past, most mainstream economists (including Krugman) agree with you.

In China, globalization, government spending on education, basic research, roads, etc. is now 'crowding out' subsistance farming, and will later 'crowd out' manufacturing and eventually in the future 'crowd out' a large portion of the service sector.

I guess, with our present cadre of economists, we'll just have to wait for China to show us the way into the future :)

[Blissex]

«This says that cutting taxes knowing that you will have to raise them again in the future is unwise because it will result in a lower level of output.»

But the ''drawn the beast'' strategy is precisely to bring the deficit to a high level by tax cuts not matched by spending cuts, and then bring out a paper saying that unless spending is cut the benefits of the cuts will turn into losses.

[Blissex]

«The tax cuts did nothing beyond buying Bush's reelection.»

Well, that's not a small achievement: keeping control of Congress and Executive has delivered immense returns on the investment of the sponsors of the Republicans (from appointments to the Supreme Court to enforcement reductions to support for foreign sponsors).

Such returns have been well worth whatever it takes.

[Bruce Webb]

Social Security took in $592 billion in contributions in 2005, close to half of which was employer match. So even if we limit ourselves to wage income under $90,000 we still end up with total payroll of around $2.4 trillion. If we added in non-wage income plus whatever amount is represented by incomes above $90,000 and below $154,000 I would think you would have a hard time keeping total cash income of that 95% under $3 trillion.

In that context financing the paydown of the current public debt of $4.8 trillion is not as daunting as it might sound.

As an example the economic numbers that separate the standard Intermediate Cost alternative and Low Cost are relatively tiny, particularly for productivity but the changes in output are huge, Intermediate Cost projects a Trust Fund in 2020 of $5.3 trillion and slowly approaching its 2023 peak, while Low Cost projeccts a Trust Fund in 2020 of $6.3 trillion and no peak in sight. By 2040 you are looking at a difference of $14 trillion. And neither model requires growth anywhere near the 3% growth rate we are currently experiencing.

I don't think the required growth rate is anything like what people are thinking. Off the top of my head I would think that just keeping the current rate of growth would do it. But as I said before whether that number is optimistic or pessimistic can really only be determined once we have it.

[Blissex]

«Those who want to make the claim that "we cannot grow out of this" need to put some numbers on the table.»

Those who want to play at being Treasury Secretary can use my little spreadsheet to compare scenarios and just check for themselves how much of a tax cut and how much extra growth is needed to come ahead:

http://WWW.sabi.co.UK/xart/D/econVoodooCalc.ods

[johnchx]

I wrote: "Since the tax cuts aren't matched with spending cuts, they add to the deficit and crowd out private investment."

But I'm wrong. A closer reading of the Treasury paper shows that there's something more complicated at work.

Basically, the "other" tax cuts (the 10% bracket, the increase in the child tax credit and the reduction in the marriage "penalty") are ones which increase household disposable income, but don't (for the most part) reduce the *marginal* tax rates on labor and capital. The result is that households consume a portion of their increased incomes as leisure -- i.e. the labor supply is reduced.

Overall, the long run result of making those tax cuts permanent is said to be a reduction in the labor supply of 0.3%. That's the main driver of the GDP reduction.

[nyuk]

What kind of "marriage penalty" relief was there? All I saw was an increase in the standard deduction. My itemized deductions are only a few dollars higher than the standard deduction, so I itemize. I saw no "marriage penalty" relief in that. It didn't change anything for me. And if it had, it would have simply negated the tax advantages I receive from home ownership. As it stands, the increase in the standard deduction has diminished my comparative tax advantage of home ownership. They should properly label it as "marriage penalty relief for married couples who don't have itemized deductions higher than the standard deduction". Very irritating.

[johnchx]

Blissex wrote: "Anyhow, all conclusions of the study are totally meaningless, as the effects not only depend on strange assumptions, but are too small to take seriously either way, considering the margins of error such estimates have."

Yep. Which, I think, is the answer to the question of why we haven't done this kind of analysis before. The results are (a) driven primarily by the spending side of the equation, so they aren't properly part of analyzing the tax package at all; (b) are highly sensitive to the specification of the model and estimation of the parameters; and (c) are vanishingly small compared with the "background noise" of forecasting error inherent in even short-term revenue projections.

It's an interesting exercise, but it's primarily of academic interest.

Not that that will stop anyone from mis-using (and mis-stating) the results for propaganda purposes. Next on Oprah: Tax Cuts Make You Thin!

[Arne]

Blissex,
I enjoy playing with numbers, but your spreadsheet is not in a compatible format.

[James Kroeger]

...a permanent extension of the recent tax cuts leads to a long-run increase in the capital stock of 2.3%, and a long-run increase in GNP of 0.7%How so?

Well, the increase in the capital stock is supposed to result from an increase in investments by firms. But how is the money that taxpayers receive from a tax cut supposed to make its way into the hands of firm managers who then use it to spend on economic investments? Answer: [typically wealthy] taxpayers will either buy stocks with the tax cut money or save it in banks (which will then lend the money to business owners/managers for their investment projects).

The only problem with this casual assumption is that money spent in secondary markets like the NYSE seldom/never ends up in the hands of firm managers. (That usually only happens during an IPO.) When securities are bought/sold in secondary markets, typically, one wealthy financial investor hands money over to another wealthy financial investor for a piece of paper. Nothing happens in these transactions that puts money into the hands of firm managers.

None of the money that households put into banks is needed for firm investments. That's right, giving rich taxpayers more money to put into bank accounts will do nothing to make loanable funds "more available" to firms with investment plans. If banks do not have sufficient loanable funds to make them available to firms at an "attractive" rate of interest, then the Fed will provide them with the funds if that is what the Fed wants. (It does this by simply buying securities; the money it uses to pay for the securities ends up in the pool of loanable funds that banks have available for lending. It is money that was not saved by any saver.)

Spencer is right. The key flaw in the argument that Republican economists are advancing is their unfounded assumption that extra money given to wealthy taxpayers will end up in the hands of firm managers for investment. In the real world, it just doesn't happen.

Because 85% of the money that corporations spend on investment comes from 'internally generated funds' (i.e., sales), if the government wants to stimulate real economic investments by firms, it would make far more sense for it to use federal funds (from taxes or borrowing) to stimulate aggregate demand. That's right, consumption, not savings.

[Blissex]

«your spreadsheet is not in a compatible format.»

it is just a ¢2 spreadsheet, but it is in the most compatible format: Open Document :-).

Just use/download OpenOffice.org which is free... To encourage a bit people to look beyond Microsoft.

[Blissex]

«the model is designed so that extra low end income is wasted in non productive activities like health care, and high end income is invested in productivity enhancing infrastructure.»

Not quite apparently, it is even better:

«The result is that households consume a portion of their increased incomes as leisure -- i.e. the labor supply is reduced.»

So it is a profoundly moral story: that the model assumes that tax cuts to the (exploitative and parasitic) poor result in them indulging their feckless lazyness, while tax cuts to the (deserving and oppressed) rich result in them working harder and producing more!

What a profound insight :-).

[Blissex]

«Because 85% of the money that corporations spend on investment comes from 'internally generated funds' (i.e., sales), if the government wants to stimulate real economic investments by firms, it would make far more sense for it to use federal funds (from taxes or borrowing) to stimulate aggregate demand»

Ahhhhhh in theory, but there is a little detail that afflicts both the ''trickle down'' story and the more plausible ''demand management'' one: that the USA is not a closed economy, and international movement of goods and capital are pretty fluid.

Even if the USA rich invest more because of tax cuts, there is no reason to assume they will invest in the USA, rather than in booming China or India (or in higher asset prices for houses that don't create value added).

Even when the USA poor consume more because of tax cuts, there is no reason to assume they will consume USA made goods, rather than those imported by Wal*Mart from India or China.

It will not be 100% or 0%, but either the ''trickle down'' or the ''demand management'' multipliers are significantly dampened.

0% and 1% nominal interest rates in Japan and the USA seem to have kickstarted a gigantic jobs and inflation boom, as it was easy to predict, but not in Japan or the USA...

No reason to imagine that more after tax income would do much of the same.

[bakho]

The 2001 recession was characterized by overcapacity and a lot of investment capital sitting on the sidelines. Even today, the Fed chairman suggests that there is an excess of investment capital. If this is the case, do tax cuts on investment income lead to more actual investment? Or do they merely inflate the price of stocks?

[Winslow R.]

johnchx wrote:

"The results are ... (c) are vanishingly small compared with the "background noise" of forecasting error inherent in even short-term revenue projections. "

Ah but so are the tax cuts. The effect is quite large compared to the size of the stimulus.

Blissex wrote:

"Ahhhhhh in theory, but there is a little detail that afflicts both the ''trickle down'' story and the more plausible ''demand management'' one: that the USA is not a closed economy, and international movement of goods and capital are pretty fluid."

The U.S. is not a closed economy, even its currency is used in other countries as a medium of exchange. Government purchases are directed by the people and initally can be spent solely on U.S. goods and services. The second round of transactions may very well stimulate worldwide demand but only while the exchange rate continues to hold and if tax policy does not soak up any excess. While currency rates do hold, it would be helpful if economists would step forward with better ideas than abolishing the estate tax for stimulating the economy. Why don't Democrats propose alternatives? Why is Krugman et. al. necktied by the idea tax policy has no effect?

Bakho wrote:

"Fed chairman suggests that there is an excess of investment capital. If this is the case, do tax cuts on investment income lead to more actual investment? Or do they merely inflate the price of stocks?"

Excess savings increases all asset prices as income streams are purchased with lower interest rates resulting in higher prices.

[James Kroeger]

Blissex:Even if the USA rich invest more because of tax cuts, there is no reason to assume they will invest in the USA, rather than in booming China or India (or in higher asset prices for houses that don't create value added).Two things need to be understood re: your comment...

One, when the rich "invest" because of tax cuts, the "investment" is only a financial investment that chases an income stream. Such "investments" are not economic investments that increase productivity or capital stock or future economic "growth." Republican love to conflate the two, but they are quite distinct. Financial investments that involve the purchase of already existing assets do absolutely nothing to improve economic capacity.

Two, governments can stimulate the good kind of investment by stimulating aggregate demand directly, i.e., by spending tax money (or borrowed money) on infrastucture, human capital, etc. The fact that we have an open economy with supposedly fluid capital and goods cannot diminish the impact of that kind of direct investment in any way.

Trying to stimulate investment by cutting taxes (to stimulate either consumption or savings) is one of the most incredibly inefficient approaches one can imagine. A far more effective way to stimulate investment would be to raise tax rates [on savings] and spend the additional revenue on real economic investments. That's right, raising taxes will increase economic investments in the economy more than cutting them will.

Why oh why haven't Democrat economists challenged their Republican brethren on this key point?

[johnchx]

James Kroeger wrote: "Financial investments that involve the purchase of already existing assets do absolutely nothing to improve economic capacity."

This is true, but it has nothing to do with the argument that lowering the marginal tax rate on capital income will increase real investment at the expense of consumption, which is the arugment of the Treasury paper (and of dynamic scoring advocates in general).

I don't agree with their policy conclusions, obviously, but I think it's important to understand what their argument really is. It *isn't* a Keynesian-style "put money in their pockets and they'll do the right thing with it" argument. In fact, the income "returned" to the taxpayer is largely beside the point -- as you can see from the fact that they conclude that raising taxes (more specifically, allowing existing cuts to sunset) on *infra-marginal* income raises investment, capital stock, and therefore long-run income.

It's all about how marginal rates affect share of output that is consumed and the share that is invested. (And we're talking about *real* investment, since it's a share of *real* output.)

Let's take an economy whose output is divided between consumption and investment at 75% / 25%. The first question is, why 75/25? Why not 70/30 or 80/20? The traditional answer is, the share devoted to investment rises or falls to the point at which the present value of the return to an additional dollar of investment is equal to the present value of a dollar of consumption (i.e. $1).

The present value of $1 of investment is, in turn, determined by three factors: (a) the real return on capital (i.e. technology); (b) the discount rate (which measures how much we prefer consuming today over consuming next year, a.k.a. the real interest rate); and (c) the marginal tax rate on capital income (because we care about the fraction of income we get to keep).

Now, there's not much a government can do about (a) or (b). (The relevant interest rate is the long-term rate, which isn't directly influenced by the Fed. Moreover, if the economy is somewhere close to full employment, the Fed won't twiddle interest rates to influence the share of output going to investment. Full employment is full employment, as far as the Fed is concerned, even if investment is 0%.)

But the government can affect (c). Lowering the marginal tax rate on capital income will make "profitable" some investments which were "un-economic" at the old, higher rates. We expect this effect to shift some fraction of income from consumption to investment. (Note that, in the short run, there isn't a material effect on total income -- we're not boosting current GDP at all; this isn't a stimulus package. In fact, we're lowering current living standards -- reducing consumption -- in order to boost future incomes.)

James Kroeger also wrote: "Trying to stimulate investment by cutting taxes (to stimulate either consumption or savings) is one of the most incredibly inefficient approaches one can imagine."

This is very true. Studies of tax-advantaged savings vehicles (like IRA's) have generally found that they're pretty ineffective and inefficient tools for boosting investment. The problem is that most of the tax benefit is "captured" by savings that would have occured anyway. And we haven't figured out a way to subsidize *only* increased, marginal savings. The same analysis, I think, applies to the supply-side tax cut argument.

But, again, the advocates of this position view public spending as having no net value -- they treat it as pure consumption, valued at cost. So the fact that large spending cuts are necessary to generate small shifts in the investment/consumption ratio isn't a problem, as far as they are concerned.

[Winslow R.]

"The present value of $1 of investment is, in turn, determined by three factors: (a) the real return on capital (i.e. technology); (b) the discount rate (which measures how much we prefer consuming today over consuming next year, a.k.a. the real interest rate); and (c) the marginal tax rate on capital income (because we care about the fraction of income we get to keep)."

I'd add business, when looking at present value, tends to look for returns in less than 5 years greatly reducing the present value of longer-term investments. Goverment is willing to invest for 18 years for future income streams and look for returns down the road (educating kids) for another 40 years where business would justly laugh at such an idea as a country 'owns' its citizens just as its citizens 'own' the country.

Point, business and government spending (investment) are two different animals, something mainstream economists ignore.