Can individual income tax reform that cuts rates and eliminates subsidies increase economic growth? How about tax cuts by themselves? The answer is: Maybe, but not by much, according to a new paper by the Tax Policy Center’s Bill Gale and Andrew Samwick, director of The Nelson A. Rockefeller Center for Public Policy and Social Science at Dartmouth College.
After looking at the effects of past tax law changes, Bill and Andrew conclude that some initiatives are more beneficial than others but overall, they do little to move the economy. Cuts in individual income taxes or even a broad-based reform such as the one proposed by House Ways & Means Committee chair Dave Camp (R-MI) are likely to produce surprisingly modest economic growth.
Bill and Andrew’s conclusions will surely disappoint supporters of both tax reform and tax cuts (which are not at all the same thing), for whom it is almost theological truth that rate cuts will stimulate growth.
President Reagan promoted growth as a key benefit of what became the 1986 Tax Reform Act. His Treasury Department called its first draft of a reform plan “Tax Reform for Fairness, Simplicity and Economic Growth.”
When Camp released his comprehensive proposal earlier this year, the accompanying press release was entitled…Camp Releases Tax Reform Plan to Strengthen the Economy and Make the Tax Code Simpler, Fairer, and Flatter.”
Such claims of a growth dividend from tax reform may look good on a bumper sticker, but, as Ira Gershwin wrote, “It ain’t necessarily so.” Same is true for tax cuts. They might boost long-term growth a bit, or perhaps not at all. Keep in mind that Bill and Andrew were focused on long-term effects, not whether tax cuts can stimulate a slumping economy in the short-run.
Any long-term payoff depends on how the tax changes are designed and, crucially, whether they are paid for with offsetting tax hikes or spending cuts. When tax cuts increase the budget deficit, any benefits of lower rates (such as an increased labor supply and capital stock), are offset by a decline in public saving that raises interest rates. Unfortunately, Washington not only doesn’t pay for tax cuts, its recent habit has been to accompany tax reductions with more spending.
At a TPC panel discussion yesterday, Bill and Andrew, along with Chye-Ching Huang of the Center on Budget and Policy Priorities and William McBride of the Tax Foundation, sorted out which tax changes can boost the economy and which can’t.
They generally agreed that the real benefit likely comes from scaling back or even eliminating inefficient tax preferences, rather than reducing rates. Those changes make it more likely that people will allocate resources to maximize their economic benefit, rather than to maximize their tax savings. If that shift is big enough, it could increase the overall size of the economy.
The panelists also agreed that while changes in the individual income tax may have relatively little effect on economic growth, other adjustments, such as corporate tax reform or a shift to a consumption tax, might be more beneficial.
Bill and Andrew cited many studies on the effects of both tax cuts and tax hikes in both the U.S. and overseas. Nearly all reached the same conclusion: On net, tax cuts just don’t do much to boost the overall economy. On one hand, they may increase incentives to work, save, and invest. But, on the other, because those tax cuts increase people’s after-tax income, they may work less and consume more, thus reducing saving. In addition, because tax rate cuts tend to subsidize old capital, they reduce incentives for new investment.
The evidence from past tax reforms is much slimmer, mostly because we have done broad-based reform so rarely. However, in 1997, Joel Slemrod of the University of Michigan and Alan Auerbach of the University of California at Berkeley found the Tax Reform Act of 1986 did little to change overall economic activity.
If it doesn’t boost the economy, is tax reform worth doing? There is still fairness and simplicity—arguments we can leave for another day. And it is always a good idea to dump tax subsidies that both add to the budget deficit and throw sand in the nation’s economic gears. But as a tool to usher in a new era of economic growth tax reform is, I’m afraid, likely to prove something of a disappointment.
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