More proof that tax cuts aren't free.

The search for better economic policy.
July 31 2006 1:16 PM

The Last Laffer

Bush's Treasury admits that tax cuts aren't free.

In Washington, as in fairy tales, be careful what you wish for. In a February speech, Vice President Cheney said, "It's time to re-examine our assumptions and to consider using more dynamic analysis to measure the true impact of tax cuts on the American economy." Calling for "dynamic analysis" or "dynamic scoring" can be supply-side code language for the view that tax cuts pay for much or all of themselves through stronger economic growth. Cheney proposed creating a new unit within Treasury to conduct this dynamic analysis and confidently predicted that it would find that tax cuts increase government revenues.

Six months later, Treasury's first dynamic analysis of the president's policies is out. It belies the claim that the Bush proposal to make his tax cuts permanent will either pay for itself or galvanize the economy.

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There has long been a conflict between responsible conservative economists who make carefully hedged claims about the relatively modest economic effects of tax cuts and Laffer curve lovers, who think that tax cuts always spur enormous gains. And lately, emboldened by the large jump in tax revenues in 2005 and 2006 (and conveniently overlooking the nearly unprecedented three consecutive years of declining tax revenues that preceded it), Laffer disciples have widened their separation from mainstream economists into a chasm.

On one side of the divide is the supply-sider in chief, who recently  abandoned six years of somewhat more cautious statements on the subject to proclaim that tax cuts really do raise revenues:

Some in Washington think the choice is between cutting taxes and cutting the deficit. This week's numbers show that this is a false choice. The economic growth fueled by tax relief has helped send tax revenues soaring.

On the other side are the intellectually rigorous, professional economists who sit across the street from the White House at the Treasury Department, who were tasked with carrying out Cheney's "dynamic analysis" of President Bush's proposal to make the tax cuts permanent. "An important feature of this model is that a permanent reduction in taxes, as compared to baseline, would lead to an unsustainable accumulation of debt," they write.

In place of a false choice of tax cuts magically paying for themselves and not costing anything, the Treasury offered a very real and painful one: The tax cuts need to be paid for by "either cutting future government spending or raising future taxes." And even if you take the path of cutting government programs—which is not the path the country is on today—Treasury found only minuscule economic effects from the tax cuts: a mere 0.7 percent increase in the size of the economy after many years.

To put that number in perspective, averaged over 20 years, an increase in the economy of 0.7 percent is equivalent to a 0.04 percent increase in the average annual growth rate. So, instead of limping along at a mere 3 percent growth rate, the economy would charge ahead at a 3.04 percent growth rate.

Notably missing from the Treasury report was the variable of greatest public interest: revenues. Although Treasury's model almost certainly estimated the degree to which the added growth helped pay for the tax cuts, officials there appear to have chosen not to report the number. But some simple arithmetic can fill in this gap: About one in every five dollars of national output is collected by the federal government in taxes. If that same ratio applies to the output added by the economic effects of the tax cuts, then the added revenues produced by the increased economic growth would be enough to offset less than one-tenth of the official "static" estimate of the tax cuts' cost.

Furthermore, all these barely perceptible benefits rest on the assumption that starting in 2017, the tax cuts would be fully paid for with cuts of unprecedented depth in federal programs—totaling about a 50 percent reduction in all domestic spending other than entitlements like Social Security and Medicare. If such cuts were not made—and not even President Bush has proposed making them—then the resulting deficits, debt, and eventual tax increases would eliminate even these modest economic benefits.

If we believe that spending cuts of this magnitude are unrealistic, then the Treasury economists have another important finding: The sooner we get rid of the tax cuts, the better it will be for the economy. Specifically, they found that national output would be 0.9 percent higher in the long run if we let them expire in 2010 rather than allowing them to continue along, forcing us to face even bigger tax increases in the future to make up for all of the added deficits and debt.

The Treasury report probably won't change the minds of supply-siders, coming as it does on top of 25 years of similar findings by economists. But it should help convert Democrats into true believers in dynamic analysis.

Jason Furman is a senior fellow and director of the Hamilton Project at the Brookings Institution.

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