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Friday, October 10, 2008

"Tax-Cut Follies"

Uwe Reinhardt says allowing the Bush tax cuts to expire would not devastate the economy:

Tax-Cut Follies, by Uwe E. Reinhardt, Economix: There is a school of economists and pundits in the United States that views tax cuts as the panacea for any conceivable economic woe, and even some social ones. They tenaciously hold on to this doctrine, even though the United States ranks as one of the least-taxed nations... (Table 2 here). ...

The school’s views are trotted out with regularity on the editorial page of The Wall Street Journal. The latest installments ... in commentaries penned by a UCLA economist, Lee Ohanian, and by former Representative Jack Kemp and Peter Ferrara. A few months earlier, a Nobel laureate economist, Robert Mundell, offered in The Journal the apocalyptic vision that allowing the Bush tax cuts to expire in 2010 “would be devastating to the world economy.” Arthur Laffer of Laffer Curve fame and several colleagues have just delivered themselves of a new tome entitled “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen.” ...

From a macroeconomic perspective,... changes in tax rates are but one of many factors that drive the time path of gross domestic product (G.D.P.), savings, investment, employment and other such variables. By itself, changing tax rates steers the economy about as much as would tapping an elephant on the leg with a chopstick. There may be some effect, but typically it is small and dwarfed by other effects.

Empirical support for this brash proposition can be found in the Economic Report of the President 2008. Table B-1 of the report features G.D.P. by year from 1959 to the present. Table B-18 lists “Private Investment” for the same years, broken down into “residential” and “non-residential” investment (that is, business investment). If one expresses the latter as a percentage of G.D.P. and plots the percentage on time, one should see in its time path the footprints of supply-side theory, which always is adduced to justify tax cuts. Supply-side theory suggests that tax cuts made economies more productive through greater investments by business. [graph]

Alas, supply-side theorists will find little support in the president’s Economic Report. Over President Ronald Reagan’s tenure, the fraction of G.D.P. devoted to “non-residential” investment fell more or less steadily from about 13 percent to 11 percent, in spite of the sizable tax cuts he got passed. That fraction fell even further, from about 11 percent to about 10 percent, under President George H.W. Bush. The fraction then rose more or less steadily from about 10 percent to about 12 percent on President Bill Clinton’s watch, in spite of the sizable tax increases he got passed. Finally, on President George W. Bush’s watch, business investment as a percent of G.D.P. fell again, from about 12 percent to about 10 percent by 2004, and this in spite of the sizable 2001 and 2003 tax cuts. The percentage rose only slightly after 2004, but is bound to decline again in the current turmoil.

I defy Professor Mundell and like-minded people to see in these macroeconomic footprints the “devastating” consequences he predicts for the world, were the Bush tax cuts not extended past 2010. ...

To think more carefully about the role of taxes in an economy, one might inquire what all these taxes support. For example, if increased taxation diverts resources from private investments in golf resorts – which is part of business investment – into government investments in infrastructure, schools, college education and biomedical research, who is to say that this retards economic growth? ...

Both President Reagan and President Bush have taught us that the mirror image of tax cuts is not cuts in wasteful government spending, but merely increased federal indebtedness, increasingly to foreigners who then can acquire our nation’s assets at fire-sale prices.

It is happening as we speak.

Right now is not the time to raise taxes, but it is certainly the time to shift the focus of taxation from the long-run and growth to the short-run and stabilization, and the case for that is strengthened by the fact that the tax cuts do not seem to have actually had much of an impact on economic growth. Thus, rather than raising taxes overall by letting the tax cuts expire, a better strategy would be to shift the tax cuts from those who don't need them and are not using them to enhance our long-run growth potential, to those who need the money to help them with the day-to-day struggle to make ends meet in a declining economy or to public sector projects that will enhance our productive capacity.

    Posted by on Friday, October 10, 2008 at 01:26 PM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (38)

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