The downside of tax cuts

By Sean Aqui | Related entries in Economy, Money, News

I’ve argued before that debt-fueled stimulus is a bad idea. Bush has borrowed $2 trillion and dumped it into the economy. That will certainly have a positive effect on short-term economic growth, just like maxing out a credit-card works pretty well in the short term.

But that’s the wrong way to look at the issue, because it will take decades to pay off the money he borrowed to achieve that effect — and that’s the best case scenario, where economic growth remains strong, spending grows at little more than the rate of inflation and all the additional revenue goes to debt repayment. Needless to say, the likelihood of any of that happening, much less all three, is slim at best.

Now the Treasury Department seems to agree with me.

The federal government will need to either cut spending or raise taxes down the road to pay for extending President Bush’s recent tax cuts, the Treasury Department said in a report released yesterday, dismissing the idea popular with many Republicans that such sacrifices can be avoided.

No duh, right? What’s interesting is that the report reached this conclusion despite using a new methodology called “dynamic analysis”, an approach supported by the administration because they think it will better show the “hidden” benefits of supply-side economics.

The Treasury report was its first using “dynamic analysis,” an approach that looks at how tax changes alter consumer and business behavior in ways that affect the economy’s growth.

A reduction in income tax rates, for example, might initially reduce the government’s revenue, but over time might encourage more people to work, and to put in longer hours, increasing tax payments to the government over time.

I don’t mind the new methodology, as long as the assumptions it uses are reasonable. Economic behavior is complex, and if a new model comes along that appears to do a better job of predicting that behavior, I’m willing to try it.

But even using this supply-side-friendly method, the economics of tax cuts come up short.

The Treasury report released yesterday relieved “a lot of fears that dynamic scoring would lead to the view that cutting taxes raises revenue,” said Jason Furman, a senior fellow at the liberal Center on Budget and Policy Priorities. Rather, the report “pours a huge bucket of cold water on the exaggerated claims that tax cuts transform the economy and pay for themselves.”

On the contrary, Furman said, the Treasury’s estimates suggest that, under the best long-run scenario, the tax cuts’ boost to tax payments would offset less than 10 percent of their initial cost.

Whoops.

Short-term, targeted tax cuts to provide short-term stimulus are an okay idea, as long as they’re not carried to extremes. Deficit spending in a national emergency is acceptable. Reining in spending is a good idea. Keeping taxes low is a good idea.

But Bush has cut taxes, supercharged spending and launched a numbingly expensive invasion, all at the same time. The mind boggles at the size of the bill the administration and its Congressional allies are handing to our children and grandchildren.

We are supposedly responsible adults. Let’s start acting like it, and start paying our own bills instead of pushing them on to future generations.


This entry was posted on Wednesday, July 26th, 2006 and is filed under Economy, Money, News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

6 Responses to “The downside of tax cuts”

  1. Dyre42 Says:

    The former head of the OMB agrees with you as well. But maybe the administration thinks that since your average American adult has ten thousand dollars in credit card debt its OK to assign every American ten thousand dollars in tax debt too.

  2. DosPeros Says:

    I would encourage everyone to go to the Department of Treasury web site http://www.treasury.gov/offices/tax-policy/ and read the report. It very, very clearly advocates for making Bush’s tax cuts permanent. (The Death Tax was not part of the study, btw).

    Furthermore, looke here http://www.whitehouse.gov/omb/budget/fy2007/ the document this Furman supposes cites for page 2 & 3 “box” — can some point me to this guys fantastic revelation? Because I can’t find it.

    I’m looking for a PRIMARY Source.

  3. Sean Aqui Says:

    Dos: The report merely notes a truism: the tax cuts will pay off better if we reduce spending. They also note another truism: the borrowed money will have to be paid back, with interest. Which is why raising taxes to do so will result in lower economic growth: you’re having to raise taxes higher than pre-cut rates in order to handle the interest load. That’s not a problem with taxes; that’s a problem with borrowing.

    Also, let’s not forget some of the assumptions inherent in the model: it assumes full employment of economic resources, ignoring the effect that government tax policy has on such employment. It minimizes international money flows — a big deal, since our huge debt could erode investor confidence in the United States. The model is also sensitive to assumptions about how people and businesses will react to changes in wages, inflation, interest rates, etc.

    Some of these are necessary features of most models. But to truly assess the validity of the projection, you have to examine the underlying assumptions. I’m bypassing that step because I assume Treasury’s model is, on balance, favorable to supply-side theory. I’m giving them the benefit of the doubt and examining their conclusions, not their method.

    The real question is, does the increase in economic growth justify the debt taken on to generate it? To calculate that you need to measure how the increased economic growth would translate to increased federal revenues.

    On Page 8, Treasury notes that a permanent tax cut without offsetting spending cuts would destroy federal finances. In other words, the tax cuts do not pay for themselves. At some point you either have to raise taxes or cut spending.

    So what they’re saying isn’t that cutting taxes pays for itself; they’re saying that in the long-run making the cuts permanent AND reducing spending to compensate would increase economic output by about 0.7 percent over the alternative: making the cuts temporary.

    What they ignore is the time frame for paying off the debt incurred — it’s measured in decades even under the best circumstances. They consider the debt manageable if it’s size as a share of GDP remains constant. Their scenario assumes ever-growing federal debt.

    That’s bad enough. But if the Republicans remain true to recent form, they will make the tax cuts permanent without reining in spending. Thus destroying federal finances.

  4. DosPeros Says:

    Sean: I’m all for reduced spending, although I would not consider myself a deficit hawk.

    I read page 8 (and it is possible we are reading different things), but it seems to be describing a necessary assumption of the “model” that was used. In other words, the model does not work (or “converge”) if one doesn’t recognize a perfect equilibrium between taxation, spending & deficit. In other words, it assumes for the purpose of comparing federal financing methods that financing will be necessary (either via tax increases or reduction in spending is necessary). This is a logical assumption that would have to be made, otherwise there is no purpose in comparing methods of federal financing. But I am still not seeing the part where the study simply declares that the tax cuts, in reality, have not able to pay for themselves — or another way of putting it — have a minimal economic effect. I just don’t see it. I see a qualifying theoretical assumption for purpose of using an economic model.

    Sean, if you can quote the specific part that supports your & Furman’s interpretation, I would really appreciate it. I could just be missing it.

  5. Sean Aqui Says:

    Dos: We read the same thing. Here’s how I interpret it.

    Treasury tried to explicitly *not* insert itself into the battle over whether Bush’s tax cuts can pay for themselves; they say as much in the introduction to the report.

    But then they went and used a model under which making the tax cuts permanent, without an offset in spending, would bankrupt the government. This wasn’t an explicit feature of the model, as I understand it; it’s a consequence. So according to Treasury, what they consider the best economic model for their purposes shows that the tax cuts won’t pay for themselves.

    You can dismiss that as a weakness of the model, but then you have to dismiss or at least reconsider the conclusions of the report, since it is based on that model.

  6. DosPeros Says:

    “The analysis reveals that the long-run effects of these policies depend crucially on how they are eventually financed and are sensitive to assumptions on underlying parameters. The issue of how, **or even if***, these policies need to be financed remains a source of discussion among economists. The analysis presented here suggests these policies will result in ***substantial more** economic activity if they are financed by a future reduction in government spending than if they are financed by future tax increases. If the tax relief is financed by future tax increases – that is, if the tax relief is temporary – it may well result in lower output in the long run. In effect, the temporary tax relief must be paid back with interest through future tax increases, which implies that future tax rates increase compared to current law. For that reason, the Administration has emphasized permanence for the tax relief and spending restraint in its Budgets…�

    Aren’t they saying, “The tax cuts are good for the economy. The tax cuts will be really good for the economy with reduced spending. The tax cuts will be less good for the economy with increased spending. But the last thing you want to do is make the tax cuts temporary.�

    Now only an ingenious, eternally optimistic mind can turn that into, “See, the tax cuts aren’t any good.� But Sean, I appreciate the discussion and the post.

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