Trick question: "Did the tax cuts pay for themselves?"

How many times have I heard that economically unimportant, politically loaded question?  A hundred I bet.  And how often do the tax cut's supporters botch the answer?  Approximately nine times out of nine. 

If I were confronted with that loaded question, here's how the Q&A would go...

Q: Did the tax cuts pay for themselves?

A: In the short run, who the hell cares?  Aren't we supposed to be more concerned with our grandchildren in the long run?

If the tax cut's supporters don't start getting the answer right, our grandchildren's generation will pay the consequences.  Tax-cut opponents are concerned primarily about winning the next election (...remember, our grandchildren can't vote yet); the tax-hikers know how to ask the trick question, and especially how to throw the knockout punch after the answer is botched as usual. 

Senator John McCain is the latest to botch the answer, and that mistake got him top billing recently at FactCheck.org, in an article titled "Supply-side Spin"; here's the article's tagline:

Sen. John McCain has said President Bush's tax cuts have increased federal revenues. But revenues would have been even higher without them.

Carefully reread that last sentence.  Here's what it means: "Tax revenues today would have been higher without the tax cuts."  Importantly, here's what it does NOT mean: "Tax revenues now and forever would have been higher without the tax cuts." 

To illustrate why that subtle difference is so important, here's a two-part brain teaser...

Part 1: Which economy would yield higher tax revenues when our grandchildren's generation takes over fifty years from now: (a) a $75 trillion economy; or (b) a $96 trillion economy? 

Part 2: Which taxation policy is more likely to enable the private sector to grow the economy the extra half-point per year it would take to achieve a $96 trillion economy for our grandchildren: (a) today's lower tax rates; or (b) yesterday's higher tax rates? 

Obviously, the missing but all-important factor in the trick question is long-run economic growth.  The $96 trillion economy fifty years from now would result from an extra one half of one percent growth.  Although it's true that tax rate cuts always reduce tax revenue in the short run, tax rate cuts set up private-sector incentives for boosting the economy's growth rate, which grows the tax base, which increases tax revenues in the long run.  If the tax cut hasn't "paid for itself" yet, it's because the long run hasn't arrived yet; i.e., it's because we haven't given compound growth long enough for its magic to become visible yet.  [For a few charts depicting those effects, see The Curse of the Free-Lunch Bunch.]

I'm sure that Rudy Giuliani, Fred Thompson, and Mitt Romney get it, and I think John McCain gets it, too, because his campaign aide had the right answer, and I presume he listens to his aides.  I just wish they'd all practice the right answer to the trick question before it comes at them again. 

[Indeed, I'd like to be able to say I think the Democrats get the growth idea, too.  But given their anti-growth tax-hiking rhetoric, that would imply I think they're dishonest schemers—so for now I'll just say I think they don't get it.  In other words, I think ignorance is a more likely explanation than dishonesty.  I reserve the right to modify that assessment as the campaign unfolds, however.]

In summary, here's the wrong way and right way to address the tax cut issue...

Wrong way (what McCain said mistakenly, because although it may be true, it is arguable):

"...the fact is the tax cuts have dramatically increased revenues."

Right way (what he should have said, because it is unarguable):

"...the fact is that tax rate cuts not only end recessions sooner, but they also help to boost growth, which dramatically increases tax revenues in the long run -- just what our grandchildren will need when they take over."

Did the tax cuts pay for themselves?  My answer is more concise: "In the short run, who the hell cares?".  No wonder I'm not a politician. 

===========
End note:
Some people think that tax rate cuts and tax rate hikes have no effect on economic growth; in other words, that people do not respond to incentives or disincentives in the taxation system.  I think that hypothesis belongs under the heading "wishful thinking," and I strongly suspect it is driven by hidden political agendas rather than rational thought.  In short, it's balderdash. 

Comments

[pawnking]

How I would answer that question:
"What is the purpose of the Federal Government? To promote maximum tax revenues or to promote maximum prosperity? Lower taxes promote prosperity, period. That is why I am in favor of them."

[Phil]

I think it was Mario Cuomo who is quoted to have said something to the effect of, "the purpose of government is not to provide services, but to make sure that certain services are provided."

I just wish we'd agree, nationally, to more of a federal system of governance, and get more services devolved back to the many States and out of direct federal control.

[Bob]

As you have stated, Steve, it's election time again. McCain's campaign is going in the tank and he's trying to stay in the game by dissing Bush, pandering to the moderates, etc.

All of these people are going to talk about taxes....I'd like to hear just one talk about economic growth directly.

As to the idea of individual and corporate incentive or disincentive generated by tax policy, here is one simple illustration I have repeated many times in my conversations. I have many business owners as clients and I have heard them bluntly say to me that they either planned not to hire more employees because they expect to have to pay more taxes, or that they planned to do more hiring because the expected tax liability for the business will be lower.
Most people understand that more jobs should lead to more growth. Simple, logical, very difficult to refute.

[Bob]

I don't know if Hillary, the probable Dem. nominee, will seek out people like this. However, she won't have worry about changing the name.

http://www.usnews.com/blogs/capital-commerce/2007/6/21/larry-summers-on-china-taxes-and-growth.html

[patrick]

very well said. we have a congressman (not mine) here in Texas named Jeb Hennsarling....he gets it. watch out for him.....I hope.

[Syphax]

Has anyone else noticed a huge flaw in the argument against the tax cuts?

Those against tax cuts argue that
A) they have led to massive deficits and that
B) they threaten our long term fiscal health.

As everyone on this site knows, argument A is bogus. The deficits incurred over the past 6 years have been small as % of GDP and the national debt is well within the historical norm.

Argument B is just as flawed. For someone to claim the US is headed down an unsustainable fiscal path and then to turn around and claim repealing the tax cuts will have any real impact is insanity.

Even if we let the tax cuts expire and unrealistically assume that revenues will rise to their peak 2000 level of 21% of the GDP, that still will NOT even come close to fixing future budget problems.

Any honest person advocating the repeal of the tax cuts needs to acknowledge that to fix our future fiscal situation we need to either dramatically increase taxes(which will slow growth and probably ACTUALLY make our current course unsustainable), dramatically cut mandatory spending or we need to speed up growth. Based on the mountain of evidence that lower taxes lead to faster growth(http://workforall.net/) I would say low taxes along with reasonable mandatory spending reform is the best solution.

The real question that should be asked to anyone advocating tax increases is... "Tax increases may increase revenues as % of GDP, but they alone won't solve the problem... so along with tax increases how would you reform spending or, perhaps more importantly, how would you speed up economic growth?"(So pretty much the question Steve has been begging someone to ask for years now)

I have never heard that question asked and I honestly don't think they would have an answer.

[Jimmy]

Have the tax cuts produced the "hidden debt" described in this USA Today article?:

http://www.usatoday.com/educate/college/polisci/articles/20070603.htm

I'm scared! Steve, help! Explain whats going on... I owe $516,328 in unpaid liabilities!! My grandchildren! What am I gonna do??

[Jimmy]

Have the tax cuts produced the "hidden debt" described in this USA Today article?:

http://www.usatoday.com/educate/college/polisci/articles/20070603.htm

I'm scared! Steve, help! Explain whats going on... I owe $516,328 in unpaid liabilities!! My grandchildren! What am I gonna do??

[TDM]

In the present, any money not taxed will remain in the capital markets and can be used to buy bonds. If taxes have no effect then the tax cuts will just pay for bonds and the added interest will increase the burden on the private economy. To pay for themselves, the tax cuts merely need to cause the economy to grow faster than the interest in the short and long run so that the private sector comes out ahead.

Another way to view tax cuts is if the marginal tax dollar will be better used to grow the economy than the marginal bond dollar. With the current marginal borrowing being mostly sub-prime lending and with many experts arguing that we need to tighten sub-prime lending it is pretty clear that we should be cutting taxes right now.

[marmico]

Huh, the bottom line is (notwithstanding the "Conover Spin") that the 2001 and 2003 and extension beyond 2010 Bush43 tax cuts will yield a whopping 0.7% increase in GDP by 2016. Oops, that assumes a concomitant spending reduction.

Ferrcrissakes, the present value of the Blackstone hedge fund IPO this week is about the equivalent.

Read the Treasury Report and weep.

http://www.cbpp.org/7-27-06tax.htm

[Steve]

marmico:
Thank you, I did see that, as well as several reactions to it, including this one from Heritage:
http://tinyurl.com/ypu8cu

The elasticity of GDP growth to the tax cuts is more arguable than the elasticity of tax receipts to the tax cuts; I confess to being more optimistic about the former than most, and will revise that stance as necessary due to new evidence. Regarding the latter (elasticity of tax receipts), there is near-unanimous agreement among economists that lower marginal rates do result in significantly more income or capital gains being reported, and therefore taxed. We are in fact seeing that today: IIT and Corp IT growing at 11% and 19% respectively, while the economy grows at 5% nominal. The tax cuts seem to be at least partially if not yet totally "paying for themselves" -- similar to the way the Clinton-era capital gains tax cut generated such large increases in tax revenues.

[JorgXMcKie]

Why can't we just have two tax structures? One for pro-growth types who want reasonably lower taxes and one for marmico and friends who want . . . what? To punish high-income earners? Slower growth? more govt control of stuff?

I'd be happy to let marmico and other tax increasers increase the tax on anyone who wanted it, so long as it doesn't apply to those who don't.

[marmico]

Steve:

1. Business investment is procyclical (coincident to GDP). Private fixed investment is now negative year over year. In other words, business is not investing in business. Business seems to be borrowing to buy back stock keeping a bid on the stock indices.

2. I'm uncertain of the source of your claim that corp IT (real equipment and software) is growing at double digit annual rates. Simply, it is not growing at all in real terms.

My data comes from the St Louis Fed.

http://research.stlouisfed.org/publications/net/20070501/netpub.pdf

3. As to the elasticity of tax receipts, I would agree that reductions in capital gains and dividend taxes will add to the capital stock of the nation more than tax reductions on other sources of income. But then it becomes a public policy issue. A few capitalists end up owning the most capital. And that is exactly what has happened this millenium.

Has it occurred to you that the current economic expansion [6 years] is slightly weaker than most post-WW2 expansions due to ineffective tax policy? In other words, the tax cuts are not pro-growth.

Geez Jorg, bring something to the table besides warmed over libertarian noodles.

[Counter Revolutionary]

mamrico, I think the IT stands for Income Tax. Slightly weaker it may be, but to assume it is tax policy is wholly undocumented. Please provide a reasonable study saying this. Reasonable is NOT some left or right wing rag.

[marmico]

Ooops, me bad. :-) It's income tax (IT) stupid, not information technology (IT), as marmico slaps forehead.

Tax receipts are growing 8% year over year in fiscal year 2007. But they grew 14.6% in fiscal 2005, 11.8% in fiscal 2006. The trend seems to be less bang for the tax cut buck I suppose.

CRev: The Treasury Department study answered your question. In the absence of spending restraint, the Bush43 tax cuts are not pro-growth. You need to answer this question: If the tax cuts were pro-growth why has investment as a percentage of GDP never recovered to 1990 levels and has recently fallen off the cliff?

[Counter Revolutionary]

Marmico, your reference earlier has no reference to policies. You may have inferred more form it than i can, but as for a direct reference, not there.

As to the investment issue, could it be that the growth rate is higher than the investment rate, thereby rates diverge? Is the investment rate part of the housing ?investment? rates and are those charts essentially similar in effects? Yes. Is it possible that the investment rate is essentially fixed by the tax laws (ah hah, a policy link.)

See, that wasn't so hard was it? just yankin your tail. Good link!

[marmico]

The source document (neither the left wing CPBB rag nor the right wing Heritage Foundation rag):

http://www.ustreas.gov/press/releases/reports/treasurydynamicanalysisreporjjuly252006.pdf

From Table 3. The long run increase in GDP is 0.7% (that is total addition to GDP not per annum addition to GDP which is a rounding error after 20 years) if the tax cuts are financed by unspecified spending cuts. The long run decrease in GDP is 0.9% if the tax cuts are financed by unspecified future tax increases.

Bottom line: Bush43 tax cuts and extensions are not pro-growth and will only increase the indebtedness of the country by ~$2T.

[Boghie]

Marmico,

I am not rich. I am now in the 25% tax bracket.

I am using 2006 inflation adjusted numbers and am increasing the 2000 tax brackets by the inflation adjustment.

If the taxes revert to the pre-2003 code I will be in the 28% tax bracket. That difference does not sound like much, but the fact is that income from $0 - $51,336 is taxed at a higher effective tax rate of 15% rather than 13% (as a side note: why should we all want the bottom two brackets to pay more income tax?).

So, under pre-2003 tax code I would pay the Feds $14,045 for exactly the same service I currently pay the Feds $11,615. Thus, from a married chap firmly in the middle class, the BusHitler tax code nets little old me $2,430 in take home pay - or a little more than $200 bucks a month. Half a car payment, or perhaps paying down the old credit cards a bit faster, maybe investing more into my retirement fund, eh… Lots of options and the government is not there to tell me how to best deal with it. And, to top everything off, the Federal annual budget will be in surplus next year – while looking at $300 - $500 billion dollar annual surpluses for as long as the eye can see if the economy doesn’t tank

Now, more pertinent to the current post by Steve. Will I simply pay the $200 each month and be happy about it?

Nope…

I will act aggressively, as I did in 2000, to reduce my tax burden. I will ‘hide’ more income from the tax man!!! I will be more aggressive in my deductions. I will stop funding a Roth IRA and increase my 401(k) contributions. And, RIGHT NOW, I will take my capital gains from investment growth and move to cash. (and, yes, Marmico that is what I am doing at the present. I want to beat the big time investors to the safety of cash and low tax rates before they act).

So, the increase in personal income tax rates will net the government $0 or maybe even a negative return as I start playing the tax game again. And, what happens to the economy as I move my resources from active assets to tax shelters?

Why should the Feds make me play the game?
Since I feel the taxes are fair I no longer play. I just pay!!!

[marmico]

Boghie, you are aware that the increase in your take home pay was not fairy dust left by Peter Pan. It is financed by debt courtesy of Uncle Sam.

Your personal income statement may have improved but your share of the national balance sheet has deteriorated. It's the same principle on a micro level as a householder re-financing and extracting equity from their home.

I'm not certain of the source of your claim for large surpluses but the Congressional Budget Office (CBO) baseline projections predict smaller surpluses starting in 2012. And those surpluses are contingent on the Bush43 tax cuts expiring in 2010.

See this CBO Table:

http://www.cbo.gov/ftpdoc.cfm?index=7731&type=0#summtable1

In any event, this post is getting off topic [what else is new in the blogoshere :-)]. Steve's argument (supply side theory) is that tax cuts incentivize and create meaningful higher growth rates in the long run. The Treasury Report debunks that balderdash.

[Steve]

marmico:
You and I obviously disagree about the effect of the 2001 and 2003 tax rate cuts on the economy, so why don't we make it a little more interesting? Let's both put some money where our mouths are. I'd put up $100, $500, or $1000, whichever you'd like to put up for your side; your choice. Let's agree on a real growth rate from April '07 through June '08 -- say, the 50-year average plus a few hundredths of one percent (which, after a few decades, would work out to the 0.7% you're hanging your hat on) -- and call that our target. If the actual turns out to be below that target, you win; if above, I win. If you don't like that target, suggest another one, and explain why.

Just an idea for making moot arguments about future outcomes more interesting. Let me know what you think.

BTW, "supply side theory" is this: "people respond to incentives." (Also, as an aside: There's no such thing as "trickle down economics"; that was merely a politically inspired bumpersticker -- and a brilliantly-conceived one, too.)

[marmico]

You have lost the debate thus far by failing to marshall evidence in support of your proposition and are now appealing to consequences of belief through bait and switch. Very fallacious debating technique, Steve. Nice try though :-)

As you know Steve, the consequence of the proposition has no bearing on the truth or falsity of the proposition. But a Mack Truck in the form of the Treasury Department smashed your ( can't resist but to make the joke that Bush43 was Snow*-jobbed) proposition to smithereens. The proposition is false. The report was all over the economic blogosphere last summer so you are a little late to the crash scene.

Besides, does it matter what the real growth rate is for the next 5 quarters (short run) in terms of the long run consequence where you have hung your hat? Ahh, the old red herring fallacy.

For what it's worth, the CBO forecasts somewhere between 2.3% and 3.0% real growth. Seems reasonable to me and a good a guess as any.

*John Snow was still Treasury Secretary when the report was being prepared (and perhaps released).

[Steve]

marmico:
I guess I should have just asked it a different way: What evidence would it take convince you to change your mind? (My guess: nothing would.)

[Counter Revolutionary]

Marmico, you are absolutely amazing. Come to Steve's house and start citing CBO? Not the smarted move. CBO is and has been clueless whn it comes to predicting future economies. Always, I say always one of the more conservative of the estimates.

Next you'll be citing OMB estimates, and for me that will be the last straw. OMB, a whitehouse agency, is part of the stealth move that has been going on for four years to pay down the debt.

Debating with credible evidence is OK, but nearly every cite you use is bad. I especially liked the St Louis Fed link. Why not pick almost any of the other charts for evidence? Oh, I know, they were mostly overwhelmingly positive.

Last question. Why ignore my explanations of what caused the down turn?

Watch out the $2T monster is loose. Ooh, Ooh as he walks off shaking his head.

[Rich Berger]

It seems to me that we've heard one phrase every year since the 2003 fiscal year - tax revenues have come in higher than expected and the deficit has come in smaller than expected. If the experts, be they in the OMB, the CBO or the President's budget message have underestimated receipts and overestimated the deficit, based on a short-term forecast, how reliable are the long-term forecasts? 20 years coming up with a number of 0.7%? Ludicrous.

"Extending the tax cuts" means keeping the current rate structure in place, not cutting taxes further. Given the surge in revenues, why do we have to increase taxes?