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
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
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
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
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
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
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
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."