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Monday, December 12, 2005

Tax Cuts, Output Cycles, and Growth

There is a lot of confusion about the effects of tax cuts, and much of the confusion is due to a failure to distinguish between two types of macroeconomic policy, stabilization policy and growth policy. To start, here's a graph of a hypothetical economy. The natural rate of output, Y*, follows an upward trend over time, and the trend has some variability in it (the degree of variability in Y* is a source of debate). The Y* line is the underlying trend of full employment output, not actual output. Actual output cycles around trend and is show as Y in the diagram (this line will be blue in the second graph to help distinguish it from other lines):

Now, let there be a tax cut at the point in time indicated in the following two graphs. Tax cuts have the potential to do two things. First, as shown in this diagram, a tax cut can stimulate a lagging economy helping it to recover faster:

In this diagram, after the tax cut, which stimulates the economy due to the deficit spending it causes, output rises faster. Thus, the data would show increasing output growth and rising tax collections. But these tax cuts do not "pay for themselves" in the sense that there is no change in the long-run growth rate of output, i.e. the underlying rate of growth in tax collections is unchanged. For that to happen, the trend rate of growth must change as shown in the next diagram:

Here, the tax cut has changed the rate of economic growth and thus will cause tax collections to grow faster as well. Most of the pro-growth people have this in mind when they think about tax cuts.

Which does the evidence suggests occurs after a tax cut? We're pretty sure tax cuts have the first type of effect of attenuating cycles, but the evidence that tax cuts affect the underlying growth rate is much more tenuous. And when you go further and ask if growth changes enough to pay for the tax cuts, the evidence is even thinner.

Anyone who says based upon a few months of data that they know which of the two scenarios is unfolding, an attenuation of cycles or a change in growth, is not telling you a straight story. Just because growth is higher and tax collections go up does not mean the second story is true. We don't know yet, and we won't know until a lot more data are available. Historically, there is reason to favor the first scenario - typically the effects are through deficit spending and the attenuation of cycles, not a change in the underlying trend rate of growth, but it is a possibility so it cannot be ruled out as implausible, and the two effects are not necessarily mutually exclusive.

If you remain unconvinced, think of it this way. Suppose the last month or two, or even the last few years, have been warmer than normal. Is this a change in the trend temperature (T*), i.e. is it global warming? Or is it just abnormally warm for other reasons, just a cycle producing higher than normal temperatures? There's really no way to tell - it takes a long series of temperatures to sort it out. The effects of tax cuts are no different. But what we do know from the data we have favors the first scenario.

    Posted by on Monday, December 12, 2005 at 12:28 PM in Budget Deficit, Economics, Taxes | Permalink  TrackBack (0)  Comments (13)


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