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


News Flash: Federal Taxes Have Plummeted

David Cay Johnston reported this a few weeks ago and I almost missed it.  It’s particularly relevant, though, what with official Washington talking about how to cut spending, restrain the deficit, etc. (at least attacking the English language with euphemisms about war in Libya).

Let’s recap what Washington, especially Republicans, have been saying (from Johnston’s article):

Notice these almost identical quotes from the Sunday morning talk shows five days after the midterms:

    We don’t have a revenue problem. We have a spending problem.
— Senate Minority Leader Mitch McConnell, R-Ky.
    Washington does not have a revenue problem. It’s got a spending problem.
— House Majority Leader Eric Cantor, R-Va.
    We do not have a revenue problem. We have a spending problem.
— House Budget Committee Chair Paul Ryan, R-Wis.
    I think it’s not a revenue problem; it’s a spending problem.
— Sen. Rand Paul, R-Ky.

As framed, these advertising lines are matters of opinion, but how many Americans recognize them for what they are — opinions, not facts?

When these people talk about taxes at all, they claim that tax rate cuts actually raise tax revenues and grow the economy.  Unfortunately the facts don’t bare that out.  In fact, tax rate cuts result in lower tax revenues.  In plain terms, tax rate cuts create deficits.  If you add a recessions to the mix, you get even lower tax revenues and bigger deficits because unemployed people don’t pay much tax.

Johnston points out, using officially released data, that we’ve had an excellent test of this assertion that “tax rate cuts grow the economy and create more tax money”.  In 2001, at the beginning of the last decade, the Bush administration pushed through a very large cut in tax rates for both high-income individuals and for corporations.   I’ve already mentioned how this has allowed General Electric to avoid paying taxes despite billions in profits. But that’s just one corporation, albeit a very large one.

How have people overall done?  Are we over-taxed as the TEA Party folks claim?  Have taxes been rising?  The answer is a very clear: NO. Despite real GDP being 17.62% higher in 2010 Q4 than in 2000 Q4., total federal tax revenues are down.  That’s why we have a huge deficit.

Federal tax revenues in 2010 were much smaller than in 2000. Total individual income tax receipts fell 30 percent in real terms. Because the population kept growing, income taxes per capita plummeted.

Individual income taxes came to just $2,900 per capita in 2010, down 36 percent from more than $4,500 in 2000. Total income taxes and income taxes per capita declined even though the economy grew 16 percent overall and 6 percent per capita from 2000 through 2010.

Let me repeat that.  Individual income taxes per person in the U.S. are down 36 percent in 2010 vs. 2000.  Now you may be skeptical.  You may be thinking, I dont’ think my taxes are down.  You may be right.  That might be because you’re in the lower 1/3 or so of income earners who only pay payroll taxes (Social Security, Medicare) but don’t pay income taxes.  You can’t pay lower than zero.  The people who pay the bulk of income taxes got the rate cuts.  Did they respond with such increased effort that incomes rose and they still pay more tax dollars at the lower rate (this is what Laffer-curve oriented Republicans claim)?  No. They pay less tax now.

But it wasn’t only high income individuals who benefitted from the generosity of Bush and the Republicans in 2001 (and again by both parties in 2010), corporations also benefitted. In particular, large multi-national firms benefitted. So what happened to the tax revenue they pay?

Corporate income tax receipts fell 27 percent and declined 34 percent per capita, even though profits boomed, rising 60 percent.

Johnston does note that payroll taxes, the taxes that workers pay for Social Security and Medicare did increase during the decade.  But these are taxes paid by all workers on income up to only $106,000.  The same politicians who falsely claim that income tax rate cuts increase revenues are in fact trying to use the deficits created by too-low income tax revenues as an excuse to cut Social Security benefits for those very workers who stepped up to the plate and paid their taxes.

There’s more damning evidence against both the politicians that perpetuate these false ideas that “tax cuts raise revenue” but also against the economists and pundits who repeat it despite the facts.  I urge the interested reader to read the whole article at:

Krugman Is Still Wrong About MMT – and with it still wrong on deficit

On Friday Paul Krugman posted the first of what has become 2-3 posts on his blog wherein he claims that MMT is “just wrong”.  As I noted Friday here, I commented on his blog to point out how his post was deceptive and misrepresented MMT.  I was not alone.  Well over 100 people have taken him task in his comments section for not having done his homework on MMT.

For those that want a more detailed refutation of the nonsense Krugman published, here’s a few links that have come up the last few days:

Bill Mitchell at Billyblog My favorite quote here:

Poor scholarship also involves not learning from your errors. You have often rightly accused the main body of our profession of having their heads in the sand (see How Did Economists Get It So Wrong?) and being inflexible in responding to the crisis.

Yet, you seem to keep wheeling the same errors of reasoning out yourself.

Scott Fulwiller writing at NakedCapitalism

The Daily Kos made three posts:

Paul Takes Another Swipe at MMT

Krugman Misleads His Readers – AGAIN!

The lesson, kids, is that even Nobel prize winners need to keep doing their homework.  If you are going to criticize some ideas, it is very important to actually read the stuff first.


Krugman on MMT

Paul Krugman comments today on Modern Monetary Theory (MMT).  Unfortunately, he gets it wrong.  For example, he says:

Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency.

I wish I could agree with that view — and it’s not a fight I especially want, since the clear and present policy danger is from the deficit peacocks of the right. But for the record, it’s just not right.

The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.

I commented and posted this response to him on his blog:

Paul, you either have an incomplete understanding of MMT or have setup a strawman. MMT does NOT hold that “deficits never matter, as long as you have your own currency.” MMT says that deficits do matter but only if (a) there’s no slack of real resources in the economy and (b) the private sector is choosing to net accumulate debt instead of accumulate net financial assets. In the meantime, however, as long the private sector wants to accumulate net financial assets, deficits are necessary to prevent Aggregate demand from falling.

You apparently prefer to use the interest rate on safe assets as the indicator of whether there’s slack real resources available – hence your emphasis on liquidity trap lingo. MMT emphasizes actual unemployment. If there’s significant unemployment, then there’s slack resources available for the government to purchase and put to use producing incomes for people.

A key insight of MMT is how the real world of banking has changed since the 1970’s when gold and fixed rates were abandoned. In our real world today, reserves do not constrain bank lending and money creation. The fears of inflation based on old equation of exchange theories are unfounded. It’s a shortage of real resources that will drive inflation, not deficits per se.

I’m not the expert on MMT. I’m just a teaching economist with both a lot of teaching and practical applied experience. If you really want to know MMT from the experts, try folks like Bill Mitchell and his Billy Blog, or Randy Wray and company at New Economic Perspectives. For that matter, read Wray’s books or Mitchell’s books.


The Misunderstood National Debt

A colleague asked for my thoughts on this article/column by Michael Manning in the State News, the Michigan State student newspaper, so I thought I’d post it for all.

Basically Mr. Manning reaches the right conclusions with a correct, but weak case. In looking at the issue of the size of the U.S. national debt and the panicked concerns many politicians are now expressing about the “urgent need to cut the deficit”, he concludes:

Republicans have decided to use this opportunity to further their party’s political agenda, feeding off of the public’s misunderstanding of national debt.

Although the debt is growing at an alarming rate, it does not mean the end of times or the end of American economic dominance. Public debt largely is misunderstood and used as a tool to scare everyday Americans.

He’s right. The debt is not the end of times nor will it end American economic prosperity (other policies may do that!).  And he’s absolutely right that public debt is largely misunderstood.

But the arguments for why it’s not a crisis and how it’s misunderstood are even stronger than he argues.  Essentially, Manning argues that most all of the debt is owed to “ourselves”, meaning either American citizens, American corporations/banks, or other units of government (Social Security program, The Federal Reserve, etc). That’s all true, but there are bigger reasons why the national debt doesn’t really matter.

He quotes Glenn Beck and then responds:

In the words of Glenn Beck, “China, some day, will want their payment, America. They will demand payment and they will receive their payment.

And if we can’t pay, they will do what any other bank would do, emotionlessly take the collateral that they now own. That will be our oil reserves, our land, our resources, our rare minerals, our coal, whatever it is.”

How much stake do these Chinese bankers actually have in America? They own a mere 7.5 percent, or about $1 trillion dollars of the national debt.

Yes, China only holds a small amount of the debt. But that’s not really why they won’t “repossess the collateral”.  The reason China won’t foreclose on the U.S. more complex. First, Glenn Beck is absolutely ignorant.  There is not “collateral” on government debt.  The only security for the loan is the “full faith of the U.S. government”.  In other words, if the U.S. didn’t want to pay, or if it wanted to payoff with new bonds, or if it wanted to payoff with newly created “money”, that’s their privilege. The lender knows that at the beginning.  There is no international court of claims where one country can foreclose on another for a bad debt.  What happens when a nation defaults on it’s debt?  Basically the lenders (usually banks in other countries) get really upset. They stamp their feet. They call serious meetings. Serious communiques are issued.  Foreign ministers get “concerned”.  Then they re-write the debt and the lenders take a loss. Nothing else.  Because it can’t!  The idea of China “emotionlessly” claiming our “oil reserves, land, our resources,” etc. is absurd.  How does Mr. Beck propose this happens?  China just pulls a couple ships up to Texas, kicks everybody out and tows the state of Texas home to China?  Or maybe China just moves in, digs up our coal and ships it home while everybody in West Virginia stands around? Or does Mr. Beck believe China will invade and forcibly take over (a nation with enough nuclear weapons to make dust of all us many times)?  It’s ludicrous.  I repeat.  The government is NOT like a household, and that means there’s no analogy between holders of US debt and a car loan or mortgage you took from the bank.

But the national debt is more misunderstood than just this false household analogy.  Indeed, it’s even misunderstood by many economists.  The issue has to do with money. The U.S. government, being (1) a sovereign nation that creates it’s own money . that (2) borrows in it’s own currency and (3) has a fiat currency with floating exchange rate, means the government (federal) cannot go broke or ever not be able to pay back bonds and interest when they are due.  This is because the government creates and is the source of the underlying “base money”.  It can always create more money to pay the bonds when due.  Now I know many folks, including many economists who haven’t updated their understanding of the monetary system since the 1971, will say “but, but, but that’s printing money and that creates inflation.”.  No it isn’t. And no it doesn’t.  The government doesn’t pay it’s bills or payoff bonds with “money”.  They send checks drawn on The Federal Reserve Bank.  Those checks are accepted by your local bank when you deposit them. When your local bank gives the check to The Fed, The Fed provides the bank with bank reserves.  Bank reserves are not money.  Bank reserves do not circulate. And, since 1971 at least, bank reserves do not limit or really influence how much money is in circulation.  How much your local bank loans out creates money.  And The Fed creates reserves to match what’s needed. (for a more in-depth explanations, see Bill Mitchell’s blog BillyBlog or the UMKC Economic Perspectives or this blog and search on “MMT”).

Now some, including many economists, claim that creating new bank reserves is inflationary.  But this is based entirely on an outdated theory called the quantity theory of money which hasn’t proven useful, accurate, or valid for over 40 years, largely because it’s based on having a gold standard or fixed exchange rates (both of which Nixon abolished).  Inflation happens when the nominal economy grows too fast and the central bank controls that through interest rates, not quantities of bank reserves or money.  I realize that some of this may sound counter to what folks may find in a lot of econ 101 textbooks, but that’s because the textbooks really haven’t been updated to reflect modern monetary theory or modern central banking operations in the way they work since the end of fixed exchange rates and gold standard.  In economics we have a problem with zombie ideas refusing to die.

Finally, there’s another very important reason the Chinese or anybody else that holds U.S. debt in large amounts don’t have a problem with the size of our debt.  That’s because the “debt” itself, the bonds, really shouldn’t be thought of as “debt”.  Government debt is really more like “paper money that pays interest”.  Again this is sovereign national debt – see above conditions.  If you are a state government or a nation like Greece or Ireland that foolishly gave away control of their currency to some foreign central bank, it’s different.  That debt is really debt.  But national, sovereign, floating exchange rate, government “debt”, the kind the U.S., Japan, Australia, U.K., Canada, and a host of other nations have isn’t really “debt”.  It’s a form of interest-paying risk-free cash.  It’s used by pension funds, banks, and investors as a risk-free asset. Indeed, at one point in the previous decade when Australia was actually paying down it’s debt and not issuing new bonds, the banking community persuaded the government to borrow anyway just so the bonds would exist.

So, Mr. Manning is correct, but he’s even more correct than he argued.  The national debt is misunderstood. And a false crisis is being created in order to push an alternative agenda.

Observations on Wisconsin

I’m noticing that the media is being somewhat slow to pickup on the real story happening in Wisconsin and not spreading to Indiana and Ohio. It’s not about fixing state deficits or finances. It’s about busting unions, pure and simple.  As such, it’s part of an long-term effort that the right wing of American politics has been pursuing since the late 1960’s to increase the share of GDP that goes to profits and elite investors and to reduce the share of GDP/national income that goes to the middle class/working class.

Steven Pearlstein of the Washington Post is starting to get it, though:

The last time any elected leader made such a direct and brazen attack on the legitimacy of the union movement was when Ronald Reagan risked havoc in the skies by firing hundreds of striking air-traffic controllers and preventing them from ever getting their jobs back. This dramatic bit of union-busting became a turning point from which organized labor never really recovered – and, like the Wisconsin imbroglio, skillfully played off resentment of public employees whose pay and benefits exceed that of the average taxpayer.

But rather than playing Reagan to Wisconsin’s truant teachers, Walker overreached, refusing to give up his union-busting even after the unions agreed to his benefit-cutting demands. Now that he has allowed the unions to reframe the issue from one of greedy public servants to one of political revenge, Walker has single-handedly succeeded in bringing more attention, unity and sympathy to the union movement than it has had since . . . well, since Ronald Reagan took on the control tower. A mischievous columnist might even take this opportunity to speculate whether this is the beginning of the revival of labor’s fortunes

Pearlstein also observes how all the conservative talk about “running government like a business” is pure nonsense.  No sane business leader interested in building a long-term successful business would approach workers this way, something I can attest to from my own corporate and consulting experiences:

Back when I was working at Inc. magazine in the mid-1980s, we loved nothing better when approaching a public-sector issue than to ask how the private sector would handle it. Faced with the situation in Wisconsin, we would have called up Tom Peters or Peter Drucker and posed the example of a new chief executive brought in by the shareholders (i.e., the voters) to rescue a company suffering from operating losses (budget deficit) and declining sales (jobs). Invariably, they would have recommended sitting down with employees, explaining the short-and long-term economic challenges and working with them to improve productivity and product quality in a way that benefits both shareholders and employees.

Now compare that with how Wisconsin’s new chief executive handled the situation: Impose an across-the-board pay cut and tell employees neither they nor their representative will ever again have a say in how things will be run or get a pay raise in excess of inflation. A great way to start things off with the staff, don’t you think? Remember that the next time you hear some Republican bellyaching at the Rotary lunch about why government should be run more like a business.

This situation, both the efforts to bust the unions and the protests, which started in Wisconsin but has spread will, I think be a major turning point in U.S. political economy.  It’s too early to tell if which way things turn.  It could spell a determined u-turn back to the early 20th century and worse working conditions and wages share of GDP/GNI, or it could be the beginning of the reversal of the 1970’s-1980 conservative revolution (is that an oxymoron?)  and a return to progressive values.  Too early to tell.