Tax Cuts, Tax Revenues, and Growth: Reconciling Theory with Evidence

Yesterday I made a post about how federal tax revenues have not increased as a result of the Bush tax cuts from 2001. Actually much of the post is based upon an analysis of official data that David Cay Johnston did.  In the comments though, William Sullivan asks:

I realize that economic growth, as measured across the last decade, is anemic at best. I think it is abundantly clear that our employment situation is awful. What I don’t understand is how these issues can be attributed to lower taxes. I recognize that ECON 202 is not the end of economic learning but Johnston’s statement seems to be at odds with what we’ve learned.

I thought his question was excellent. It’s the type of question people and principles students should ask in response to an article.  Since I think my response will be useful for future students I decided to answer Mr. Sullivan with a new post (I can find it easier in the future then).

Initially, a quick read of both my post and Johnston’s article does leave the impression that we’re saying “tax cuts don’t stimulate the economy”. Yet we (I) teach in principles of macro classes that “tax cuts are one way of implementing fiscal policy to stimulate the economy”.  So how do we reconcile the theory with the evidence?

Here’s how I do it.  We need to be more precise in both what’s being measured and in what claim or theoretical assertion is being tested.  First let’s look at the linguistics of the three variables of interest here. The controversy or confusion is about the relationship between these 3 variables are:

  • tax rates – the % of income that by law needs to be paid as income (in more sophisticated analyses we should distinquish between marginal rates, the rate paid on additional income vs. average or effective rates, which is tax $ paid divided by income. For now, tax rates are sufficient.
  • tax revenues – the total dollars of taxes collected by the government in a particular year.
  • GDP – the total size of the economy.  Since GDP is roughly equal to gross domestic income, we can basically say this is what the economy earned each year. For our purposes here, we’ll call this “the economy”.

The first issue is lazy semantics that politicians and sometimes economists often use.  They often will use the phrase “tax cuts”. But what does “tax cuts” mean?  We always have to careful about what’s meant when somebody says “tax cuts”.  It could mean “reduction in tax rates” or it could mean “reduced tax revenues”.  We really have to look at context to see what’s meant as I’ll illustrate a little later.

Now the next question is what are the different propositions or assertions that are made about the relationships between these variables.  The first relationship is the purely accounting, definitional relationship and shouldn’t be controversial at all. Namely, in any given year, the average tax rates times GDP = tax revenues.  This is really the idea that taxes are basically income taxes. We earn income as a nation (GDP) and we pay a percentage (tax rates) of it to the government (tax revenues).

Now let’s look at the claims that have been asserted.  Roughly put, there are two separate questions or assertions to be tested here:

  1. Lower tax rates will stimulate the economy (GDP) so much that tax revenues will rise (or at least not fall).  In other words, if tax rates are cut, both GDP and tax revenues will increase.
  2. Lower tax rates will stimulate the economy (GDP) but tax revenues will drop.  In other words, if tax rates are cut, GDP will grow but not grow enough to keep tax revenues from falling.

The difference is important.  If #1 is true, then we don’t have to worry about increasing the federal deficit when deciding to cut taxes. This is what Bush and Republicans asserted to be true in 2001 and most recently in 2010 and 2011. Republicans in Congress have been arguing recently that tax cuts won’t make the deficit worse.  They only way that can be true is if #1 holds true. The essence of the data that David Cay Johnston presented and that I quoted was in response to this assertion.  The data clearly shows that tax rates were cut and tax revenues fell.  They not only fell, they fell by a lot. It’s important to note that tax revenues fell even in the “growth” years before the Great Recession hit in 2008.  One implication of this is that assertion #1 is clearly false. Tax rate cuts do not stimulate the economy enough to keep federal tax revenues from falling.  Therefore, anytime tax cuts are proposed we need to realize they will add to the deficit.  Tax rate cuts make the deficit worse.

Now let’s consider assertion #2 above.  This is really a simplified version of what we teach people in principles classes:  tax cuts can stimulate the economy. This is simple Keynesian theory.  I think, though, that economists have been too lax in how we state this idea  (myself included – I ask for forgiveness!). We don’t clarify what’s meant by “tax cuts” and we don’t clarify the mechanism.  Strictly speaking, the idea is that tax rate cuts will reduce the taxes collected by government (revenues) and if they result in increased spending (aggregate demand) then GDP will increase. The trick here is that tax rate cuts will allow households/corporations to have more after tax income (also called disposable income). Then, if they spend that additional after-tax income, then GDP will rise.  In this sense, when Keynesian economists say “tax cuts” they’re usually meaning lower tax revenues, which most probably happened by tax rate changes.

So, in looking at the data, should we reject or accept the idea of assertion #2.  In this case, I think it’s important to look at a broader historical record than just the Bush tax cuts of 2001. What we see is that tax cuts (as in lower tax revenues) tends to have a stimulating effect on GDP, but the strength of the effect varies widely.  In other words, reducing tax collections (lower tax revenues) will sometimes grow the economy strongly and at other times it will barely have any effect.  If virtually never has a negative effect, unless it was combined with spending cuts.  What makes the difference?  A lot depends on how the taxes are cut and for whom they are cut.  This is because the critical linkage is whether they tax cut will increase spending.  To the extent a tax cut is just saved by the household or used to pay down debt, it doesn’t help the economy grow. This is the difference between the Bush tax cuts and say an earlier, more successful tax cut like the Kennedy-Johnson tax cuts in 1964. The Bush tax cuts were overwhelmingly targeted at top-bracket, high-income individuals and corporations.  Instead of spending the tax savings, these people largely saved the money and converted it into financial assets. Spending in the economy did not get much of a boost.

So in conclusion, I think we can say assertion #2, what we teach in class, is viable, but we really need to be clearer:

tax cuts will stimulate the economy and grow GDP if we implement the tax cuts in a way that they get spend and not saved, but they will worsen the deficit.


What we have here is really three different variables that we need to keep track of


Supply Chain for Future Garage Sales Disrupted

Although this came out a couple weeks ago, it is appropriate for today.  Apparently rising food and gas prices, stagnant incomes, and unemployment are threatening the very American way of life.  This could potentially disrupt production in China and disrupt the supply chain for future garage sales. (emphasis mine)

Consumers Say Recession Changed Way They Blow Paycheck On Crap

WASHINGTON—A survey released Monday by the U.S. Department of Commerce found the nation’s weakened economy has drastically changed the way consumers blow their paychecks on useless crap.

The report suggests the lingering recession has forced Americans to make tough choices when it comes to pissing away their earnings, as millions struggle to find new, and often challenging, ways to be completely irresponsible with their finances.”The sad truth is we have to keep track of every single penny if we want to be able to spend money on shit we don’t even remotely need,” said Nebraska resident Dennis Schmeltzer, 42. “What am I supposed to do? I’ve got three kids. This family buys a lot of dumb crap, and suddenly we don’t have so much wiggle room when it comes to wasting our money like assholes.””On the one hand, it kills me to go another month without winged-skull seat covers for our Suburban, but on the other, I can’t bear the thought of my kids opening the kitchen cupboard and finding only three or four different kinds of Doritos,” Schmeltzer added. “But right now we just can’t have both. It’s a nightmare.” 

The economy’s sluggish recovery appears to have altered consumer overspending habits in a manner not seen for decades. Sixty-three percent of survey respondents said they were “significantly more reluctant” to squander their income on massaging bath pillows, prepackaged apple slices, motion-activated candy dispensers, devices that make it easier to crack eggs, and just about anything with a fucking Ed Hardy design plastered on it. Another 18 percent said they decided not to buy any more trampolines for at least six months.

With fuel prices rising and the cost of food at an all-time high, experts have said Americans have far less cash to recklessly fritter away. However, many have reportedly managed to continue splurging on stupid shit by finding ways to make their wasted dollars go further.

read more at the source

Public Safety Alert

From Crooked Timber, today, April 1, 2011:

Public safety alert

by Michael Bérubé on April 1, 2011

Washington, DC – The National Governors Association has announced a voluntary product safety recall of sixteen governors, due to a structural design problem that could pose an immediate safety risk to consumers.

“We didn’t know, when we made these governors available to the public, how truly dangerous they were,” said an NGA representative who requested anonymity because he feared swift and remorseless retaliation from one of the defective governors.  “In most cases, they seemed like fully functioning human beings.  But now it appears that many of them avoided routine safety checks or managed to buy off safety regulators.”

In Pennsylvania, defective governor Tom Corbett has recently barred safety inspectors from issuing citations of his office for safety violations, following on his Department of Environmental Protection’s unprecedented demand that environmental inspectors in Pennsylvania stop issuing violations against natural gas drillers without prior approval from the DEP.  In Wisconsin, defective governor Scott Walker has issued demands for the email records of everyone who has typed the words Scott Walker, recall, collective bargaining, AFSCME, WEAC, rally, union, Alberta Darling, Randy Hopper, Dan Kapanke, Rob Cowles, Scott Fitzgerald, Sheila Harsdorf, Luther Olsen, Glenn Grothman, Mary Lazich, Jeff Fitzgerald, Marty Beil, Mary Bell, Rachel Maddow, or fruit bats since January 1 of this year.  And in Florida, defective governor Rick Scott has eliminated an anti-fraud database that would track the fraudulent dealings of defective governor Rick Scott, following on his attempt to kill an anti-fraud database that would track the fraudulent distribution of addictive prescription drugs in Florida.

“These guys are clearly a menace to society,” said consumer watchdogs Albert and Allen Hughes.

But according to the National Governors Association, the problem has spread beyond the initial “bad batch” of gubernatorial products recently purchased by unwary consumers.  “It’s not just the new crop, almost all of whom contain toxic and potentially lethal levels of wingnuttery,” said an industry spokesman.  “It’s a public hazard of almost epic proportions.  You’ve got governors like Bobby Jindal making fun of early-detection systems for natural disasters.  You’ve got Jan Brewer’s crew looking for anyone who speaks with a funny accent.  You’ve got Haley Barbour reminiscing fondly about the white-supremacist Citizens Councils.  So it’s not just a question of a few bad eggs like Alabama’s Robert Bentley refusing to acknowledge non-Christians as his ‘brothers and sisters.’  It’s grounds for a total recall.”

Even some conservative voters have begun to express “buyer’s remorse.”  “I liked this brand of governor because they yell at teachers, so I bought a whole case of ‘em,” said Roger Waters, an unemployed man from upstate.  “I hated the way teachers were always telling me to read and think and stop hitting people and stuff.  But then I find out that they’re killing train lines and cutting off my unemployment checks.  I asked one of them about creating jobs, and he said something about seceding from the federal government.  I asked another one about all the crumbling bridges and tunnels in the state and he said ‘abortion abortion abortion abortion.’  I don’t get it.”

The recalled governors are Haley Barbour (Mississippi), Robert Bentley (Alabama), Jan Brewer (Arizona), Sam Brownback (Kansas), Chris Christie (New Jersey), Tom Corbett (Pennsylvania), Mitch Daniels (Indiana), Nathan Deal (Georgia), Dennis Daugaard (South Dakota), Nikki Haley (South Carolina), Bobby Jindal (Lousiana), John Kasich (Ohio), Rick Perry (Texas), Rick Scott (Florida), Rick Snyder (Michigan), and Scott Walker (Wisconsin).  Jerry Brown (California) and Andrew Cuomo (New York) are also being monitored for public safety violations, though consumer advocates warn that their potential replacement governors may give off deadly noxious fumes.  “Don’t forget what happened last time we issued a recall in one of those places,” said Anthony Kiedis of the Institute for Advanced Californication.  “They wound up with some guy who went through nightclubs and malls shooting people.  Even when they tried to blow up his oil truck and crush him in a drill press, they couldn’t get rid of him.  So you take your chances.”

The National Governors Association has issued a warning that continued prolonged exposure to defective governors may cause severe corrosion of public works and irreparable damage to the social fabric.  If your body politic comes into contact with any of the recalled governors, wash thoroughly with soap and water to prevent toxic effects such as rashes, burns, abrasions, lacerations, boils, and excessive bleeding.  Reported side effects include loss of workplace protections, civil liberties, reproductive rights, drinkable water, health coverage, pensions, hair, memory, and eyesight.