In a recent post we talked about the best kept secret in Washington: supply-side effects of debt-financed tax cuts are negative. To back this up we cited a just-released CBO study and 2003 report from the Joint Committee on Taxation. Here's some additional supporting research:
(1) In a 2002 article in the National Tax Journal by William Gale and Samara Potter concluded that the Bush tax cuts reduced the size of the economy. As we have stressed in these posts, the distinction between debt-financed and budget-neutral tax cuts is crucial:
- Our results do not show that reductions in tax rates have no effect, or negative effects on economic behavior. Rather, the improved incentives--analyzed in isolation--unambiguously increase economic activity, by raising labor supply, human capital, and private saving. Indeed, these factors raise the size of the economy by almost 1 percent. But [the 2001 tax cut] is a set of incentives-- financed by a reduction in public saving. The key point for understanding the growth effects is that the tax-induced increase in private saving is a only a small faction of the decline in public saving, so that [overall] national saving falls substantially. The decline in national saving reduces the capital stock, even after adjusting for international capital flows, by sufficient amounts to reduce GDP and GNP.
(2) A March 2003 Congressional Budget Office study, using models similar to those employed by Gale and Potter, found that the Bush tax cuts because they were deficit financed would have little, and possibly negative effects, on long-term growth. When this report was released the CBO Director was Republican-appointed Douglas Holtz-Eakin. Holtz-Eakin would subsequently join the White House staff and then be the top economic adviser in 2008 McCain campaign.
(3) A new report from the International Monetary Fund, addressing on the worldwide (U.S.-excepted) push for budget austerity, concludes that deficit reduction will improve long-term economic growth. It follows that deficit-financed tax cuts (something very few other countries are considering right now) would hurt long-term growth.
Astute readers have already noticed that all this negativity about tax cuts has only been directed to the "long-term." What about short-term effects? Well, most of these models do conclude that short-term effects of debt-financed tax cuts are positive. This should be welcome news to the pro-tax cut crowd but it creates a huge blockage to the logical flow of their arguments. The short-term effects are Keynesian. They are, in fact, pure economic stimulus. "Stimulus" has become a dirty world and any agreement with the positive short-term effects of tax cuts requires acceptance of the idea that stimulus proposals work. Worse still for conservatives, once you acknowledge stimulus effects exist, the logical next step is to conclude that policies likes tax cuts for the poor and increases in government spending are more effective than tax cuts to the rich because the latter have less ability to stimulate aggregate demand. That's textbook Keynesian economics. The chart on page 11 of this CBO presentation illustrates the point.