The Agenda

Brief Note on Recent Conversations About Taxes

James Pethokoukis has written a reply to David Leonhardt’s recent column on the relationship between tax rates and economic growth that is worth reading. Leonhardt makes one valuable point, drawing on Donald Marron of the Tax Policy Center:

When the top marginal rate was 70 percent or higher, as it was from 1940 to 1980, tax cuts really could make a big difference, notes Donald Marron, director of the highly regarded Tax Policy Center and another former Bush administration official. When the top rate is 35 percent, as it is today, a tax cut packs much less economic punch.

“At the level of taxes we’ve been at the last couple decades and the magnitude of the changes we’ve had, it’s hard to make the argument that tax rates have a big effect on economic growth,” Mr. Marron said. Similarly, a new report from the nonpartisan Congressional Research Service found that, over the past 65 years, changes in the top tax rate “do not appear correlated with economic growth.”

I found the juxtaposition with the CRS report unfortunate, as the CRS report — to my surprise — failed to engage with the work of Prescott, Rogerson, and Chetty, among others. Arpit Gupta has discussed taxes and labor supply in this space, and he has a forthcoming article in National Review on the same broad subject. Moreover, it overlooks the issues Scott Sumner has raised, along with Pethokoukis and Brink Lindsey and many others, with regards to making growth comparisons across different economic eras. 

Regardless, Marron’s point is well-taken. (Also, see our recent discussion of Harvey Rosen on the behavioral effects of cuts in marginal tax rates.) A 70% to 50% reduction in the statutory top marginal tax rate is likely to have a bigger impact than a reduction from 39.6% to 35% or from 35% to 28%.  

Leonhardt also discusses the composition of tax cut packages, but he doesn’t spend as much time as he could have explained explaining the underlying issues:

“To me, the Bush tax cuts get too much attention,” said R. Glenn Hubbard, who helped design them as the chairman of Mr. Bush’s Council of Economic Advisers and is now a Romney adviser. “The pro-growth elements of the tax cuts were fairly modest in size,” he added, because they also included politically minded cuts like the child tax credit. Phillip L. Swagel, another former Bush aide, said that even a tax cut as large as Mr. Bush’s “doesn’t translate quickly into higher growth.”

In the fall of 2010, Josh Barro discussed the CBO’s assessment of the high-income rate reductions as opposed to the other Bush-era tax cuts aimed at low and middle-earners:

In the CBO’s strong labor response model, a full extension of the tax cuts knocks 0.6 percentage points off of GNP, whereas a partial extension as proposed by President Obama (which would raise earned and unearned income tax rates on most filers making over $250,000 per year) would cost 1.2 points of GNP. That is, a partial tax cut extension is worse for the economy than a full extension, even though the full extension grows the national debt by more. 


The implication is that the extending the portion of the tax cuts that principally benefits high earners would grow GNP by 0.6 points, despite such an extension’s effects on the deficit. It is the rest of the tax cuts (lower marginal rates in the bottom four brackets, marriage penalty relief, the higher per child tax credit, etc.) that do not stimulate enough economic activity to offset the added debt burden.

Even if you prefer CBO’s weak labor response model (which assumes workers have low sensitivity to tax treatment), the presentation shows equal economic damage from a partial or full extension, despite the fact that a full extension grows the deficit by about a third more than a partial extension.

As we’ve said on numerous occasions, it is entirely possible that the CBO is wrong. But if it is anywhere close to right, we’re in a funny position: the “pro-growth elements of the tax cuts” are politically unpopular; the other elements are almost universally embraced by Republicans and Democrats, and these popular elements represent roughly 80% of the total cost of the Bush-era tax cuts. Had Leonhardt explained that the “pro-growth elements of the tax cut” were those aimed at high-earners, he would have shed light the political challenge. 

In Pethokoukis’s reply to Leonhardt, he mentions President Clinton’s embrace of a deep cut in capital income taxation — the rate was cut from 28% to 20%. President Bush then presided over a cut to 15%. It’s by no means obvious that this was a magic economic elixir, and many argue that a shift to consumption taxation would be more beneficial, e.g., Alan Viard.

But consider Greg Mankiw and Matthew Weinzierl’s findings regarding cuts in capital taxes, as summarized by Matt Nesvisky:


According to the researchers, the neoclassical growth model and all of its variants indicate that the dynamic response of the economy to tax changes is substantial. In almost all instances, they find, tax cuts are at least partly self-financing. The authors conduct some simple calculations, plugging in numbers that approximately describe the U.S. economy. They find that, in the long run, about 17 percent of a cut in labor taxes is recouped through higher economic growth. The comparable figure for a cut in capital taxes is about 50 percent. This means that the true revenue cost of a cut in capital taxes is only half of the cost estimated with static scoring.

These results depend on a number of key assumptions, which are open to debate. Mankiw and Weinzierl acknowledge that current studies do not afford clear guidance about how best to apply the neoclassical growth model to the actual economy. Economists will need to focus next on evaluating which generalizations of the basic model are the most salient and then on estimating the key parameters. 

This is hardly the last word on the subject, but it is certainly worthy of note.


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