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Created 7/30/1996
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Dole's Forty Percent Solution

Why "Dynamic" Effects Will Amplify Revenue Losses from Tax Cuts

James Bradford DeLong


James Bradford DeLong is Associate Professor of Economics at the University of California at Berkeley. He is a partisan Democrat. From 1993 to 1995 he worked for the U.S. Treasury as Deputy Assistant Secretary for Economic Policy



Sometime in the near future the Republican standard-bearer, Robert Dole, will announce his economic program: a large tax cut.

The last time big tax cuts were in the Republican Party's platform, little attention was given to the impact of such tax cuts on federal finances, the national debt, and the American economy. Politicians talked of how stronger economic growth would lead to rising revenues. Politicians made gestures in the direction of a small tribe of supply-siders, who claimed that cutting tax rates would increase revenues. But the general feeling was that the Democrats had had so much success with tax-and-spend that it was time to try to counter it with spend-and-borrow, and that if the economy and the budget got into serious trouble as a result of the tax cut they could always fix it later.

Well. it''s later. The American economy and the federal budget did get into serious trouble. Things are still not completely fixed. American productivity and living standards are lower, and the country weaker, than had the1980s seen the economic policies of, say, an Eisenhower.

Yet once again the Republican Party is set to run on a platform of large federal tax cuts.

This time there will be no handwaving about cutting rates not reducing revenues. This time tax cuts will be "paid for": offsetting spending cuts will be proposed. Or, rather, some spending cuts--for it looks like former Senator Dole will claim that faster growth will replace forty percent of revenue lost, so only sixty cents' worth of spending need to be identified for every dollar of tax cut.

But there is every reason to think that this claim is wrong, and that a dollar's worth of tax cut, as assessed--"scored" is the word used--by the Congressional Budget Office will widen the deficit by much more than a dollar.

Why? Begin with the link between the federal deficit and national savings. An extra dollar cut from taxes is an extra dollar added to the deficit, an extra dollar borrowed from the public, and thus an extra dollar not saved and invested by Americans in boosting the country's productive potential. Cut taxes by $100 billion, leave them lower (and the deficit higher) for a decade, and find after a decade that $1000 billion of America's productive capital stock is missing--and that this loss of productive capital has reduced GDP by some $100 billion a year, and that the missing GDP has caused a further revenue shortfall of some $30 billion a year.

Continue with the link between high national debt and high interest rates. If you had told someone in the late 1970s what the actual rate of inflation has been in the 1990s and asked them to predict interest rates, they would probably have forecast interest rates two or three percentage points below today's values. Why are today's U.S. interest rates so high? A prime suspect is the budget deficits of the 1980s that have left us with a high national debt. If correct--and I think it is--a $100 billion tax cut sustained for a decade would leave us with interest rates higher by perhaps a percentage point, and with annual federal spending on debt interest higher (both because of more debt and because of a higher interest rate on existing debt) by some $100 billion.

Go a step further, with the link between high federal borrowing and the collapse of America's export industries that was so evident in the 1980s: a dollar borrowed from Japanese investors to finance the federal deficit is a dollar that is not spent on America's exports. I still have not seen a good analysis of the social cost of the destruction of midwestern export industry in the 1980s as a byproduct of the overvalued dollar induced by the federal deficit. My personal back-of-the-envelope guess--I won't even call it an estimate--is that this is another $30 billion reduction in annual GDP in this context, and another $10 billion in lost revenue.

Conclude with the positive supply-side effects of lower tax rates in boosting economic activity at the margin and in reducing the amount of tax avoidance. These effects are there. As Charles Schultze likes to say, there was never anything wrong with supply-side economics that dividing by ten would not cure. In assessing these effects the devil is in the details. But for a tax cut aimed at America's broad middle class it does not seem unfair to take Schultze at his word, and divide the supply-sider estimate by ten: instead of a cut in tax rates not reducing revenues, suppose that the $100 billion tax cut generates an extra $10 billion in revenues from expanded GDP--and throw in an extra $10 billion from reduced tax avoidance to be generous.

But note that this is a two-edged sword. Spending cuts to offset tax reductions have negative supply-side effects of their own: reductions in infrastructure investment may be very costly in reducing growth, reductions in spending that supports education lower Americans' skills and GDP, and reductions in business investment may well be (I think probably are) much more expensive in terms of lost GDP than standard rules of thumb allow. Do you gain more in added GDP from lower taxes than you lose from the reduction in public investment as spending is cut? I think not.

If you asked me for my best estimate of how much of the tax cut would be offset by the revenues generated by faster economic growth, I would say much less than zero: itt would shift the direction of the American economy in such a way that after a decade the deficit would be higher not by $100 billion a year but by something like $240 billion because the higher deficit leads growth to slow and interest payments to rise.

I know of no serious economist who thinks that the U.S. economy is in better shape now than had we followed Eisenhower-style economic policies in the 1980s: everyone's assessment of the past fifteen years is that the early 1980s tax cuts set in motion a dynamic that reduced savings and investment and slowed growth--and thus amplified, not offset, the revenue lost from the early 1980s tax reductions. Thus when I hear Republican political operatives say that one dollar of tax cuts will only reduce revenues by sixty cents (and that such an assumption is an act of conservative prudence), I get frightened. I fear that the old Republican political operative medicine of rosy scenario and falsified forecast is back.

So I hope Robert Dole backs off, and does not do what his handlers are priming him to do. Policies based on rosy scenarios are bad for the country, if implemented. Yet campaign promises that are not implemented poison the presidency that repudiates them.


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Created 7/30/1996
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Associate Professor of Economics Brad De Long, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/