Paul Krugman: The Bush Tax Cuts and the Deficit

Much has been written here and elsewhere (here too) regarding the Bush tax cuts and the deficit. Many claim that the tax cuts didn't increase the deficit. Instead, the claim is that the tax cuts increased economic growth enough to bring about an increase in tax revenues and reduce the deficit. Let's see if Paul Krugman can help. Is there any evidence out there that can help to convince us one way or the other? Are tax cuts the answer to the deficit problem?

The Bush Tax Cuts and the Deficit, Paul Krugman, Money Talks, NY Times: ...Here are two pictures that may help show why claims that the tax cuts were good for the deficit are wrong. Chart 1 shows federal receipts as a percentage of ... G.D.P.... These receipts plunged starting in 2001, then made a partial – but only partial – recovery over the past year. It’s useful to bear in mind that estimates of the size of the Bush tax cuts put them at about 2 percent of G.D.P. The actual fall in revenue as a share of G.D.P. was much larger ... Even now, revenue is about 3 percent of G.D.P. below its peak...

So revenue as a share of GDP fell after the tax cuts? Why did that happen?

The most likely answer is that by the end of the 1990’s revenues were inflated by the stock market bubble ... When the bubble burst, revenue fell off. ... Back in 2001 ... I argued that predictions of big future surpluses, which were used to justify those [tax] cuts, were wrong – and one reason I gave was that federal revenues were inflated by the stock bubble, and would soon fall.

That explains the past, but the news stories on the deficit are about the present. What's been going on with revenues recently? Why have they been increasing?

Data from the Congressional Budget Office show that ... the revenue surge came from two places, profits taxes and “nonwithheld” income taxes. Profit taxes surged partly because profits themselves surged – this has been an economic recovery in which real wages for most workers have actually gone down, so that profits have gathered the lion’s share of the gains – but also because a temporary tax break instituted in 2002 expired. We don’t know for sure why nonwithheld income taxes surged, but the best guess is that it reflects a bounce in stock prices during 2003-4 and, probably, a bubble in housing. Both are one-time events...

I'm not convinced yet. Here's why. Suppose taxes are cut and GDP growth goes up by, say, 3%, and because of the robust growth in GDP suppose that taxes increase by 2%. Then wouldn't taxes as a percentage of GDP fall? Doesn't that undercut your argument above which relies upon the taxes as a percentage of GDP falling as a sign of falling revenues?

Well, no. ... [E]ven now real G.D.P. is considerably lower than most people thought it would be ... Chart 2 shows, for each quarter since the beginning of 2000, the average growth rate of real G.D.P. over the previous five years. At the end of the 1990’s, people thought that the economy would grow at ... more than 3 percent a year. In fact, economic growth since 2000 has averaged only about 2.5 percent... The bottom line is that there is nothing in the data to suggest that the Bush tax cuts have had a favorable effect on the budget deficit.

Then why are the claims that tax cuts reduced the deficit by increasing revenue so widespread?

The answer, of course, is that wiggle at the end of the line in Chart 1. Revenue is still low by historical standards, but it’s not as low as it was last year. And as a result, the budget deficit actually came down in fiscal 2005, albeit to a level that would have seemed shockingly high a few years ago...

But isn't that better? Shouldn't we be cheering the recent upswing in revenue?

Well, put it this way: if a student gets a D after a string of F’s, his performance has improved – but that doesn’t put him at the top of the class.

Given this and other evidence suggesting the same thing, I'm convinced.