Do Tax Cuts Spur Economic Growth? The GOP Thinks So
Business + Economy

Do Tax Cuts Spur Economic Growth? The GOP Thinks So

iStockphoto/The Fiscal Times

Here’s Republican House Speaker John Boehner’s promise for cutting the deficit and avoiding the fiscal cliff: Trim tax rates and close deductions and loopholes, under the assumption that a simpler tax code spurs vibrant economic growth that adds hundreds of billions of dollars in new revenues.

“By working together and creating a fairer, simpler, cleaner tax code, we can give our country a stronger, healthier economy,” Boehner told the media Wednesday. “A stronger economy means more revenue, which is what the president seeks.”

But that theory – dating back to Reagan’s “supply-side” economics of the 1980s – doesn’t hold up. Economists and former congressional staffers say the historical record shows that the tax cuts almost never pay for themselves, let alone reduce the deficit.

The policy gets sold as reducing the deficit by what’s called “dynamic scoring”—that is, economic models that give upbeat estimates of how tax cuts affect the behavior of businesses, investors and consumers. It’s an open secret that this type of budgetary scoring is notoriously inaccurate. Any plan relying on it could increase anxieties about government efforts to rein-in the deficit and sidestep the fiscal cliff.

“The markets would view this as unrestrained deficit increases that are masked by kind of questionable predictions,” said John L. Buckley, a professor at Georgetown University Law School who was formerly the chief Democratic tax counsel for the House Ways and Means Committee. “If you have another tax cut with a pretend dynamic scoring estimate attached, I don’t think the markets would see that any differently than a pure tax cut.”

Buckley has done an exhaustive study of reforms starting with the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986. He found that subsequent events never lived up to the ambitious claims made at the time about  the positive impact of lower tax rates on investment, savings, wages, economic growth and federal revenues.

“If dynamic scoring is used to determine budget estimates, there is a risk that financial markets will no longer accept budget estimates on faith,” Buckley said.

Market skepticism already abounds about the estimates being used by government officials. With President Obama’s reelection on Tuesday, formal negotiations will soon begin with congressional leaders over how to reduce the deficit and avoid a year-end calamity of more than $600 billion worth of tax increases and spending cuts that threaten to send the economy into another tailspin.

President Obama will make his first post-election comments Friday about actions needed to avoid the fiscal cliff, according to the Associated Press.  In his address from the White House East Room, the president is expected to urge Congress to act, including passing a bill that would prevent Bush-era tax cuts from expiring for all but the wealthiest Americans. However, he not expected to put forward a specific plan, but instead will call on lawmakers from both parties to work together to tackle the nation's fiscal problems.

David Kotok, chairman and chief investment officer for Cumberland Advisors, an investment management firm, wrote this week, “The government’s projections are now rigged by congressionally-made rules which dampen their credibility.  We expect no change in this congressional deception in 2013.”

What Boehner proposed in remarks Wednesday to the media was lower tax rates by closing deductions and spending reductions on entitlement programs like Medicare – all policies pushed by the vanquished Republican challenger Mitt Romney in the presidential election

Obama prefers raising the income tax rates on American families earning more than $250,000 to generate revenues. Rep. Chris Van Hollen of Maryland, the top Democrat on the House Budget Committee, told National Public Radio yesterday that he was highly skeptical of the Republican offer.

"In the past, whenever they've talked about tax reform as part of a revenue-raising measure, they have simply claimed, contrary to all historical evidence, that simply reducing tax rates will generate enough economic activity to make up for the loss in revenue," Van Hollen said.

Conservative members of Congress and outside groups have repeatedly called for the use of "dynamic scoring" to estimate the budgetary effects of major legislation. Last February, the Republican-controlled House passed a bill requiring the Congressional Budget Office and the Joint Committee on Taxation (JCT) to prepare "dynamic" estimates of how major tax and budget legislation might change the overall economy.

The CBO, Joint Tax Committee and other federal agencies already account for many policies that change individual and business behavior. However they do not include estimates of “macroeconomic feedbacks” -- that attempt to estimate how much a change in tax or spending policy would affect the overall economy, according to a report by the Center on Budget and Policy Priorities.

Former CBO Director Rudolph Penner has written, “The fact of the matter is that economists differ significantly in their assessment of the effects of tax cuts. . . . There may come a day when there is sufficient agreement about dynamic effects to automate the process using powerful computers. But we are many decades from such technology.”

Even conservative economists sympathetic to Republicans concede that depending on dynamic scoring involves considerable guesswork and risky assumptions – especially given the fact that even widely accepted government economic forecasts are often wrong.

“The problem that we continue to have as a nation is our scorers at the Office of Management and Budget and Treasury in the administration and Joint Tax and CBO for the Congress have at best rudimentary tools for answering those questions,” said J.D. Foster, an economist with the conservative Heritage Foundation. “The models are not correct and they can only suggest a direction and rough order of magnitude.”

Following Tuesday’s election that kept Democrats in control of the White House and the Senate and Republicans with a strong majority in the House, Obama and Boehner each made conciliatory gestures toward a grand bargain of tax and entitlement reforms that would slow the growth of the more than $16 trillion national debt. Along with that deal, they must also agree on a plan to block the negative effects of the fiscal cliff awaiting the country on Jan. 2.

Any deal relies heavily on a series of flawed economic assumptions. The U.S. economy has a mind of its own and rarely conforms to projections, something the Obama administration knows firsthand from its own 2010 budget proposal.

That budget was based on growth that never materialized—with gross domestic product surging by 4 percent in 2011 and accelerating to 4.6 percent in 2012. That strong economic rebound was supposed to cause the budget deficit to fall from $1.4 trillion in 2009 (actual number) to $581 billion this year (projected). Instead, economic growth poked along at 1.8 percent last year—less than half the projection—and 1.77 percent so far this year. The federal deficit stayed above $1 trillion this fiscal year.

Previous administrations—including Ronald Reagan’s—were similarly optimistic. The Economic Recovery Tax Act of 1981 cut individual tax rates by 23 percent over three years, with an immediate reduction in the top marginal rate from 70 to 50 percent. The Senate Finance Committee report recommending its enactment said the package would drive economic growth, business investment, and personal savings. 

Those predictions did not come true, according to research by Buckley, the Georgetown University tax expert. The personal savings rate dropped from 11.3 percent in 1981 to 7.5 percent in 1986. The reduced marginal tax also had no discernible positive effects on labor supply or consumer demand.

Martin Feldstein, chair of the Council of Economic Advisers for President Reagan, and CBO Director Douglas Elmendorf concluded that the economic recovery after 1981 was not a "result of a consumer boom financed by reductions in the personal income tax" and that there was "no support for the proposition that the recovery reflected an increase in the supply of labor induced by the reduction in personal taxes." Rather, they credited expansionary monetary policy as the "primary cause of increased output."

The Tax Reform Act of 1986, which sought to simplify the tax code by lowering marginal tax rates and eliminating deductions, was also enacted with the hope of fostering an "efficient allocation of investment" and productivity gains in the long term.

At a conference years later that looked back on the reform, Brookings Institution economist Henry Aaron summarized the findings of most papers that the reform “had little effect on the broad measures of real economic activity in which most economists are interested."