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July 26, 2006

A Teachable Moment

The Treasury Department has released a new analysis of "the President’s proposal to permanently extend the tax relief provisions enacted in 2001 and 2003 that are currently set to expire at the end of 2010."  It is attracting its share of controversy, of course, but interestingly the argument does not seem to be about its reliance on "dynamic analysis using a model that accounts for the effects of this greater work effort, increase in savings and investment, and improved allocation of resources on the size of the economy." 

Writing in today's Wall Street Journal, in an article reproduced on Greg Mankiw's blog, Robert Carroll (Deputy Secretary for Tax Analysis) and Professor Mankiw summarize the key lessons from the report:

Lesson No. 1: Lower tax rates lead to a more prosperous economy...

Lesson No 2: Not all taxes are created equal for purposes of promoting growth...

Lesson No 3: How tax relief is financed is crucial for its economic impact.

That last bit provides the foundation for criticisms from Daniel Gross, from Menzie Chinn, and from Brad DeLong.  At issue is this (from Mankiw and Carroll):

The Treasury's main analysis assumes that lower tax revenue will over time be accompanied by reduced spending on government consumption. But the report also shows what happens if spending cuts are not forthcoming. In this alternative scenario, a permanent extension of recent tax relief is assumed to lead to an eventual increase in income taxes.

The results are strikingly different. Instead of increasing by 0.7% in the long run, GNP now falls by 0.9%.

Says DeLong:

What proportion of students will be able to follow the syllogism?

    • Tax relief is good for growth only if the tax reductions are financed by spending restraint.
    • The Bush tax reductions have been financed not by spending restraint but by borrowing.


    • The Bush tax reductions have been bad for growth.

I hope the answer is none, because one of the premises is irrelevant.  The question is not have the tax cuts been financed by spending cuts, but rather will they be financed by spending cuts.   Brad's expectation may be reasonable given the politics of the situation, but you obviously cannot draw conclusions by assuming a condition that has yet to be determined.

Menzie Chinn has a better point:

It is important to understand that there is no welfare calculation undertaken, despite the fact that under certain conditions, GNP is higher than under baseline. That is because undertaking a welfare analysis would require taking a stand on the utility associated with government spending on goods and services. So even if one were to take the Treasury's high end estimate for the long run steady state effect, the answer to the question of whether tax cuts are desirable depends upon the utility associated with spending on civil servant wages, bridges, and body armor.

Very true, and wouldn't it be nice to have a serious discussion about those trade-offs?  And while we are at the business of pointing out that either spending or taxes have to give, why not put even more aggressive tax reform back on the table.  Carroll and Mankiw report:

According to the Treasury analysis, a permanent extension of the recent tax cuts leads to a long-run increase in the capital stock of 2.3%, and a long-run increase in GNP of 0.7%.

Contrast those numbers with these, from a Treasury report released a few months ago on the dynamic effects of tax reform s that would, to varying degrees, shift the tax burden away from saving and capital accumulation:

.. models suggest that the [Growth and Investment Tax] recommended by the [President's Advisory Panel on Federal Tax Reform] could lead to long-run increases in the capital stock ranging from 5.6 to 20.4 percent and long-run increases of national income ranging from 1.4 to 4.8 percent. The simulated growth effects of the [Simplified Income Tax] plan were considerably smaller, with long-run increases in the capital stock ranging from 0.9 to 2.3 percent and national income increases ranging from 0.2 to 0.9 percent. The growth effects of the [Progressive Consumption Tax] were the largest of the three plans, with long-run increases in the capital stock ranging from 8.0 to 27.9 percent, and long-run increases in national income ranging from 1.9 to 6.0 percent.

Now we're talking real money.  I'd have a lot more sympathy for the call to raise taxes rather than cut spending if the former came with an advocacy for some real tax reform.

Other interesting items:

Gerald Prante at Tax Policy Blog notes:

[The] final paragraph of the report is interesting because it shows that the better way through tax policy to increase long-run economic growth is to target directly at marginal tax rates, whereby people make their economic decisions, and not to mess with credits, deductions, phase-outs, phase-ins, etc, which have little economic value.

Mark Thoma makes a good, although somewhat subtle, catch:

I want to point out that Lesson 1 summarizes the effect of the policy on the level of output, a movement to a new steady state. It is not a change in economic growth... Quoting from the report, "In the steady state, per-capita growth in the model is equal to a constant rate of technological change." I've missed something somewhere. The commentary is about changes in economic growth, not changes in the level of output, so it would be helpful to see the connection between tax cuts and the (constant) rate of technological change explained further since an increase in the rate of technological change is needed to increase the growth rate of per capita output.

I think the answer is that Carroll and Mankiw are being a little fast and loose with their language.  If the long-run level of income is higher under a particular policy, then it must be the case that the growth rate of income is higher than it would otherwise be for some period of time along the transition from the old policy to the new one.  In the short-run or medium-run, the growth rate of the economy is stimulated, even though there is no impact on growth in the long run.

UPDATE: pgl adds his thoughts at Angry Bear.  I especially think his admonition that there is often a tension between short-run stimulus and long-run capital formation is worth taking to heart.

July 26, 2006 in Taxes | Permalink


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Listed below are links to blogs that reference A Teachable Moment :

» Tax Cuts Debate from Economic Investigations
Macroblog has a nice summary of the discussion, so far, on the US Presidents proposed extension of tax cuts, A Teachable Moment, starting with the initial comments of Mankiw Ive linked to previously, in the Dynamic Tax AnalysisR... [Read More]

Tracked on Jul 27, 2006 9:11:54 AM

» A Teachable Moment from TruePress
Macroblog takes a look at the various economics blog reactions to the recently announced Treasury Department calculations of the GNP effects of permanently extending the 2001 2003 tax cuts.  ... [Read More]

Tracked on Jul 27, 2006 9:22:22 AM


Thanks for summarizing the economist blog debate so far. After I read the Treasury report, I was rather shocked at the bait and switch arguments in it. More over at Angrybear.

Posted by: pgl | July 28, 2006 at 07:33 PM

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