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Treasury Report on tax cuts
Posted by: Jon Henke on Friday, August 25, 2006

A recent Treasury Department study (now with dynamic analysis!) of the stimulative effects of the tax cuts has some potentially important results...but it's hard to decipher just what those are. Forbes cuts to the chase. The good news is, keeping the tax cuts will increase growth by .7%!
The economy would get a boost if President Bush's first-term tax cuts were made permanent, but only if other taxes were not raised to pay for the lost revenue, the Treasury Department said Tuesday.

The department estimated that the economy's annual output could be boosted by 0.7 percent in the period beyond 2016 if the reductions in tax rates and other tax cuts passed in 2001 and 2003 are made permanent.
Annual growth increases of that size would be far too consequential to ignore.
On the other hand, to get this additional .7% growth, the study assumes that beginning in 2017, government spending is reduced to pay for the tax cuts."

So, you know, never mind.

And if Congress hiked taxes to "make up the lost revenue", then "the higher taxes in other areas would reduce economic output. . .by 0.9 percent annually [Jon: "???"] in the years after 2016."

This is the potentially enormous news. Annual growth increases of that size would be far too consequential to ignore. As Albert Einstein allegedly said (though he probably didn't), the most powerful force in the universe is compound interest. A yearly +.7% or -.9% would, over decades, amount to trillions of dollars in additional or lost progress.

Unless it doesn't.

The Treasury Report says that "making the tax relief permanent can be expected to increase the level of annual output by about 0.7%." But what do they mean by "annual"? The answer to that question could be the difference between a remarkable vindication of supply side ideas and/or the Bush tax cuts. . . .and a complete evisceration of the layman supply side arguments that the Bush tax cuts would 'pay for themselves' or increase federal revenue. So which is it?

Jason Furman writing at Slate claims the Treasury Report "found only...a mere 0.7 percent increase in the size of the economy after many years" — that is "a 0.04 percent increase in the average annual growth rate." (more on that here) But the Treasury Report [pdf] says that "making the [tax cuts] permanent can be expected to increase the level of annual output (i.e., national income) ultimately by about .7%." Both Forbes ("0.7 percent annually") and the Washington Post ("economic activity would be increased by about 0.7 percent per year") present the 'per annum' argument, while the Center for Budget and Policy Priorities takes the 'one-time' view.

In any event, as Bloomberg writer Amity Shlaes points out, progress is not made by tax cuts alone.
While tax cuts may generate future growth, they can only do so if the government spends less. To make their model work, the authors had to assume that government purchases would decline after 2017. Barring the crowning of Newt Gingrich as American King, this premise seems a stretch. Unless the U.S. government curtails spending, the report says, public borrowing will crowd out private investment. In addition, the Treasury model suggests, ``across the board, proportional tax increases'' will follow. The president's goal of permanent tax cuts becomes impossible.
This is central to future debates about tax policy and economics.
Without corresponding spending cuts, simple tax cuts are not especially helpful in the long run. (though some cuts, such as cuts in corporate taxes or capital taxes, are certainly more efficient than others)

So, we have one of two options here. Either:
  1. The Treasury Department's dynamic analysis indicates that the Bush tax cuts + spending cuts would cause such dramatic growth that, as the CPBB put it, "it would increase the size of the economy by 40 percent after fifty years", which would be an enormous vindication of the tax cuts and would lead to the conclusion that the tax cuts did, indeed, pay for themselves. Or...


  2. The Treasury Department's Report was grossly misleading when it described the increase in terms of "annual output". In fact, the additional growth attributed to tax cuts plus nonexistent spending cuts is so small that any further argument that we are on the right side of the Laffer Curve, or that this kind of tax cut would 'pay for itself' should be dismissed as prima facie evidence of economic ignorance. Based on the Bush administration's own projections.

In light of the fact that the administration is not touting this 0.7% additional "annual output" from the rooftops, I suspect that means the correct choice is #2. This is central to future debates about tax policy and economics.
 
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Wow. A clear, cogent, honest analysis of tax cuts and fiscal policy. More articles like this and the site could actually live up to its motto. Kudos.
 
Written By: william
URL: http://
The article says keeping the tax cuts would create an additional 0.7% in growth annually, but it’s not quite clear what the author(s) mean. Do they mean that instead of seeing, say 2.9% GDP growth in a given year, we’d actually see 3.6% — in other words, apply the 0.7% to the GDP? Or do they just apply the 0.7% to the growth (0.7% of 2.9 is about 0.02, so small as to be meaningless)?

In the former case, it’s a significant boost to the economy..in the latter, it’s a "don’t care term".
 
Written By: Steverino
URL: http://steverino.journalspace.com/
Well, I don’t know if I would call it "meaningless", but "not worth it" might qualify.
 
Written By: ozymandias
URL: http://
There is no use in arguing about this, The projections are not very good or reliable either those of the CBO or those of independent reviewers.
There is no doubt that we are near the point of equilibrium on the Laffer curve.
My argument is not that the last bunch of tax cuts might not have deprived the Government of some revenues. My argument is that past reductions, especially those where rates were over 50%, did.
At any rate, I am opposed in principle to giving the government more money. There is so much that can be cut before we even think of taxes. Futhermore, any significant tax increase now on top of high energy prices might tank the economy.
 
Written By: kyle N
URL: http://impudent.blognation.us/blog
In the former case, it’s a significant boost to the economy..in the latter, it’s a "don’t care term".
It’s neither. If I read the report correctly, it means that, 20 years hence, the economy will be .7% larger. As the CPBB described it, that would be about 90 billion dollars in additional output. That’s not inconsequential, but additional growth of .04% a year is pretty close to it when you’re discussing major tax policy and supply side predictions of increasing growth so fast that the tax cuts will ’pay for themselves’.
There is no use in arguing about this, The projections are not very good or reliable either those of the CBO or those of independent reviewers.
Econometrics is a very tricky field, but I think you’d find that predictions about the effect of a single policy are more accurate than predictions about the state of the entire economy. So, predicting ’what the economy will look like’ 20 years from now is pretty much a crapshoot, but predicting what effect, e.g., an extra 1% yearly productivity growth, or a lower tax rate on income/capital would have is a bit easier. Of course, that’s not to say they’re perfectly accurate. I just want to distinguish between the two modeling problems.

Also, it’s worth mentioning that long-term modeling has been reliably unreliable in the past precisely because they used static analysis. This report finally incorporate dynamic analysis, so it purports to solve that problem.
 
Written By: Jon Henke
URL: http://QandO.net
(1) Not intenting to discredit the Laffer Curve; but in reality, it is impossible to know where we are on the curve. So economic policy base on Laffer Curve is unwise.

(2) Supply economic is nothing but a version of Keynsian economic; instead of approaching the economy from the demand side; it approaching the economy from the supply side. From a libertarian economic standpoint; it is contrary to the principle of neoclassical economic. Government cannot stimulate the economy, whether through increase spending or tax cut. The government in fact should do absolutely nothing to stimulate the economy. It will recover on its own. Beside, there was no tax cut. Real taxation is the amount the government spent. If anything, G.W. Bush gave us a tax increase.

*There was an inteview in 2001 with Milton Friedman in which he stated that he favor tax cut in principle but disagree that tax cut actually stimulate the economy.
 
Written By: Minh-Duc
URL: http://
Couldn’t someone ask Treasury to clarify its poorly written, ambiguous report? Jon, you do a great job of setting out the either/or on what they could be claiming, but the real solution is to press them for clarification here. I’m not saying you should do this - you’re a blogger! But all these Established Media EnterpriseTM outlets ought to stir themselves.

Otherwise, Minh-Duc nails it. Of course there’s a Laffer curve. We can reason its existence from first principles. What we can’t do is reason where the max is on the Laffer curve, and thus know whether we’re on the upslope or the down slope.

As to his point two, I’m like, yeah. Consider that Laffer curve justifications for tax cuts amount to "We should do this because the government will have more money to spend." Anterior to determining what government should be spending money on, the Lafferite declares that the government should be getting more - or, at least as much. The Lafferite is granting the premise that the purpose of tax policy is to maximize government revenues. When people figure out that we’re actually on the up-slope of the curve and not the down-slope, statists can press for tax increases and the Lafferites will have already given away the rhetorical game.
 
Written By: Jim Henley
URL: http://www.highclearing.com
It’s no accident that this report is so ambiguous (or misleading). If the past 30 years has taught us anything it’s that basing policy on projections that include spending cuts down the road is a bad idea.

And there’s a reason the tax cuts of the past few years were temporary. And it’s pretty pathetic to claim, as this administration has, that to allow them to expire as they were originally designed to do by this administration, amounts to a tax increase.
 
Written By: Davebo
URL: http://
in reality, it is impossible to know where we are on the curve
It’s almost certainly impossible to know precisely where the inflection point of the Laffer Curve is (i.e., the precise point between the right and left side), but it’s perfectly clear that we’re currently on the left side of the curve. Otherwise, the evidence would indicate higher economic and revenue growth from tax cuts.
Beside, there was no tax cut. Real taxation is the amount the government spent. If anything, G.W. Bush gave us a tax increase.
Agreed!
*There was an inteview in 2001 with Milton Friedman in which he stated that he favor tax cut in principle but disagree that tax cut actually stimulate the economy.
I would be surprised if he said that tax cuts do not stimulate the economy. It’s almost axiomatic that they do. The serious objection is to using fiscal policy (including tax cuts) as a response to recessions. The lag is just too big for them to have a big effect on a recession. (excepting, of course, massive, permanent cuts when taxes are at prohibitively high levels which simply no longer obtain in the US)
Couldn’t someone ask Treasury to clarify its poorly written, ambiguous report?
I think that’s absolutely necessary, especially in light of the fact that so many credible news organizations reported it as ’yearly’ growth, rather than one-time growth. Perhaps I should call the Treasury Department for a clarification...or even check with the WaPo ombudsman. After all, if it’s a one-time increase, then they need to make a correction.
 
Written By: Jon Henke
URL: http://QandO.net
It’s almost certainly impossible to know precisely where the inflection point of the Laffer Curve is (i.e., the precise point between the right and left side)
Can’t - control - math - nerdery! Parabolic curves don’t have inflection points. They have a max or a min.

Sorry. Couldn’t help myself.
 
Written By: Jim Henley
URL: http://www.highclearing.com
No fear, I can use all the math nerd help I can get. I’d major in economics if I didn’t have such a low tolerance for math. Sadly, I do, so I try to avoid the math and stick to theory.

What’s the correct term? Equilibrium point?

And separately, why has this report — and the obvious conclusions I pointed out above — not gotten more attention?
 
Written By: Jon Henke
URL: http://QandO.net
It’s almost certainly impossible to know precisely where the inflection point of the Laffer Curve is (i.e., the precise point between the right and left side), but it’s perfectly clear that we’re currently on the left side of the curve. Otherwise, the evidence would indicate higher economic and revenue growth from tax cuts.
No, Jon, that’s not right. If we were on the left side of the curve, we’d actually see negative economic and revenue growth from tax cuts. I’d say we’re very near the breakeven point — near enough that further tax cuts won’t bring enough growth to be worth it — but still on the right side of that point.
’d major in economics if I didn’t have such a low tolerance for math. Sadly, I do, so I try to avoid the math and stick to theory.
Back when I was in college, we used to say that the limit (as GPA approaches 0) of a math major is an econ major. :)
 
Written By: steverino
URL: http://steverino.journalspace.com/
If we were on the left side of the curve, we’d actually see negative economic and revenue growth from tax cuts.
That’s not an accurate representation of what the concept of the ’laffer curve’ purports to show. The laffer curve says nothing about negative economic growth. It merely argues that revenues will rise or fall past a certain point of diminishing returns, as the tax rate affects decisions. In our case, we’ve got very solid evidence that mild tax hikes do not reduce revenue and tax cuts do decrease it beyond what it would otherwise be in the absence of tax cuts.

Greg Mankiw’s research has indicated that tax cuts on income will eventually repay about 17% of the lost revenue through stimulatory effects, while tax cuts on capital will eventually repay close to 50% of lost revenue through stimulatory effects. Note that neither of those suggest — even in the long term — that the tax cuts would repay 100%+ of the lost revenue.
 
Written By: Jon Henke
URL: http://QandO.net
No, Jon, that’s not right. If we were on the left side of the curve, we’d actually see negative economic and revenue growth from tax cuts. I’d say we’re very near the breakeven point — near enough that further tax cuts won’t bring enough growth to be worth it — but still on the right side of that point.
Nah. As Jon pointed out, the Laffer analysis doesn’t predict negative economic growth at any point along the curve. Even (especially?) a negative tax rate would produce economic growth. As to positive vs. negative revenue growth, it’s always tricky figuring out how much to attribute to a tax cut/increase, and how much to attribute to something else. Assuming we have more revenue today than in 2000, after adjusting for inflation, this does not necessarily mean the tax cuts didn’t have a negative impact on revenue. Maybe most of the recovery would have happened anyway, and revenue would otherwise be higher today than it is.

None of this means tax cuts are a bad idea, of course. All it means is that cutting taxes to increase government revenue is probably a bad idea. Cutting taxes to promote business and/or starve government is a great idea.
 
Written By: Xrlq
URL: http://xrlq.com/
In our case, we’ve got very solid evidence that mild tax hikes do not reduce revenue and tax cuts do decrease it beyond what it would otherwise be in the absence of tax cuts.
There is no way to know that since you can’t simultaneously do both and observe the results.

All of these arguments are purely theoretical because they are based on "all things being equal". But all things are never equal including private and public spending and borrowing decisions, Fed policy, internal and external shocks, the health of the world economy, etc., etc., etc.

The problem with all this analysis is that taxes are only one portion of the equation. "All things being equal" I am certain that the peak of the laffer curve is well below 18% of GDP. But there is absolutely, positively no way to prove it either way because we can’t run experiements where we take the same initial conditions and test both ways. The only comaprison is to theoretical projections, which are notoriously bad. So we’re left with endless debate where the numbers can be made to say anything you want them to.

But here’s what I do know: From a top marginal tax rate of 91% all the way down to 28% and back up again to 39% and back down to 35% government revenues have consistently been between 16% and 20% of GDP. Playing with the tax code only has a small effect on government revenues. But it has an enormous effect on the long term health of the economy. Since the rate reductions of 1981 the economy has boomed and 40+ million new jobs have been created, we had the longest, most robust economic expansion in U.S. history interupted by 2 relatively mild recessions and have accelerated past all other nations to achieve the highest standard of living in the world. That’s supply side economics regardless of the theoretical amount of revenue that theoretically could have been collected.

We are living in Ronald Reagan’s supply side economy whether we realize it or not.
 
Written By: DS
URL: http://

 
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