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Friday, June 10, 2011

Deficits More Than Pay for Themselves

The old "tax cuts pay for themselves" justification for cutting the tax rates of the wealthy is back:

despite a host of Republican economists telling them otherwise, Republican policymakers can’t resist arguing that tax cuts pay for themselves. That’s the old voodoo economics.

There's no evidence that tax rates have ever come close to paying for themselves at tax rates such as the US imposes, so it's a justification without merit. In fact, there's no evidence that the Bush tax cuts had any effect on growth at all (see here too). The claim that tax cuts are self-financing is snake oil, and if the press was doing its job any politician saying this would immediately be labeled as a fraud (Ryan's budget proposal makes this claim). Yet it lives on.

Just for fun, did you know that deficits more than pay for themselves?

Suppose the nation needs a key piece of infrastructure, a public good the private sector has trouble providing for itself. If the government puts the infrastructure into place through deficit spending, it will increase private sector growth for as long as the infrastructure remains in place, i.e. until it wears out (it could be replaced, but I want to focus on a single project). If the extra tax revenue from the higher economic growth rate covers maintenance costs, the cost of the project, and then some, then the project more than pays for itself. It won't cost taxpayers a dime. In fact, it will save them money.

The problem, of course, is that just as in the private sector it is very unlikely that the economic growth rate would increase enough to actually generate sufficient revenues to cover the costs - it would take a substantial increase in economic growth to do that (into the Pawlenty zone of infeasibility).

Let me emphasize that this says nothing about whether a project benefits society. The tax revenue a project generates through increased growth is different from the economic benefits of a project. In some cases there is little relationship between revenue and benefits, so whether a project generates sufficient tax revenue to pay for itself says nothing about whether it is worthwhile to society. That's not a test of private sector projects -- the requirement is simply that the benefits exceed the costs -- and the same is true for public sector projects. For example, providing public parks may not do much for growth, and they may generate little if any revenue, but they can still be a net positive when willingness to pay for parks is compared to the actual taxes that are collected.

A broader point here is that tax cut proponents often point to the private sector benefits of a tax cut, the increased growth, tax revenue, employment, trickle down benefits, etc. that supposedly occur. But they rarely look at what is lost from cutting public spending to pay for the tax cut (or, if spending isn't cut, the costs of the deficit that is created -- deficits Republicans profess to fear so much due to their very high costs). If what is lost in the public sector from cutting spending (or from creating a long-term budget problem) is more than what is gained in the private sector, then even though it may be possible to point to private sector gains, overall the tax cut was harmful.

I'm not arguing that every cut in taxes and spending would result in a net loss to society. There are certainly areas where government spending could be cut (and other areas, like health care, where we could get net positive returns from expansion). But we should at least consider what we give up when we cut spending (or increase the deficit) to pay for tax cuts, something those who argue for tax cuts as the solution to any and all of the nation's economic problems rarely rarely do. If, for example, the cost is important social programs or key pieces of infrastructure, then society may very well end up worse off.

    Posted by on Friday, June 10, 2011 at 02:07 PM in Budget Deficit, Economics, Politics, Taxes | Permalink  Comments (38)


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