Dynamic Scoring and Tax Cuts Paying for Themselves
In two previous posts I have argued that the idea that the tax reciepts are paying for themselves (in other words, are the sole reason tax revenues are increasing) is a load of baloney. Now there are a couple of working papers (one forth coming in the Journal of Public Economics) that support my position.
Before getting into the the two papers I want to point out that my position isn’t that the tax cuts haven’t had a stimulus component to them. The exact opposite is true. I think the tax cuts were one of the reasons why the last recession was so short and shallow. So if any commenters are inclined to make a strawman argument that I think that tax cuts didn’t do any good, please tatoo this paragraph on your forehead.
Typically, the effect of changes in tax rates is determined by static scoring. With static scoring all feedback effects of changes in the tax rate are ignored. If there are positive feedback effects then the cost of the tax cut (in terms of decreased revenues) is overestimated. If their are negative feedbacks, then the cost is overestimated. So the questions is what are these feedback effects like? On one extreme there is the group that says that there is no positive (or negative) feedback effects. These are the people that think that static scoring of tax changes is sufficient. At the other extreme are those who many would consider supply siders who argue, via the Laffer curve, that the tax cuts can either pay for themselves or even generate an increase in revenues.
The first paper is by N. Gregory Mankiw and Matthew Weinzierl (both at Harvard, and Mankiw was Bush’s former head of the Council of Economic Advisors). This paper looks at the dynamic impact of labor tax cuts (think income taxes here) and a cut in taxes of capital (capital gains taxes). To look at this Mankiew and Weinzierl utilize the neoclassical growth model first put forward by Ramsey in 1928.
In the most simply form of their model, Mankiw and Weinzierl note that changes in the capital tax rate is not the same as in the static case. However, the nature of the feedback depends on the parameters of the model and the tax rates. For the simple model, Mankiw and Weinzierl pick what they argue are plausible paramters/tax rates and find that in the case of a cut in the capital gains tax that the tax cuts pays for 50% tax cut.
Mankiw and Weinzierl then generaliz their simple model in a number of ways such as including elastic labor supply, a more general production technology, and so forth. One of the findings here is that a cut in the labor tax will pay for about 17% of the tax cut. Not nearly as large as many who claim the tax cuts are driving tax reciepts would probably like. Still, the conclusion here is that under the right conditions tax cuts can, at least in part, be self-financing.
The next paper (sorry no link to the paper, I had to purchase it via NBER) by Eric Leeper and Su-Chun Susan Yang looks at the results attained by Mankiw and Weinzierl and relax the assumption that “the government’s budget constraint is always satisfied”. What does that mean? It means that one of Mankiw and Weinzierl’s assumptions is that the government’s budget is always balanced. Mankiw and Weinzierl themselves note that this is likely an unrealistic assumption and that their results should be regarded as a “first step”.
Leeper and Yang find that the dynamic impact of tax cuts relative to the state impact depends on financing mechanisms as well as the model callibration. In some instances the tax cut can actually cost more in dynamic terms than the static. What does that mean in more simple terms? It means that debt financed tax cuts might actually lower growth.
These two papers represent some important steps forward in investigating the impacts of tax cuts on the economy. The idea that one can deduce the impacts simply by giving the issue a few minutes thought is false. The rhetoric often espoused by conservative commentators (both on blogs and the radio) that tax cuts always increase tax revenues is also false. Similarly, the idea, often espoused by liberal commentators, that debt financed tax cuts are always bad is also false.