Christina Romer's appointment to the chair of the President's Council of Economic Advisors is excellent news. Her recent papers on taxation with David Romer represent a real advance in blending economic theory with rigorous and ingenious historical research. Of course, good economics isn't always good politics, which leaves high-ranking academic economists in a bit of a tight spot as they attempt to help the administration meet its aims while also attempting to maintain their professional reputation as social scientists. (This is, I imagine, rather harder for right-leaning economists such as Mankiw and Holtz-Eakins, already a distinct minority even in economics.) I'm interesting to see the extent to which Obama's excellent economic team will and won't be willing to diverge from their expert opinion in order to provide political cover for bad economic ideas. Goolsbee's truth-telling campaign gaffe about Nafta comes to mind.
In honor of Romer's appoinment, I reprint the post I wrote about her and David Romer's recent work on taxes over a year ago for Free Exchange:
- Posted by:
- Free Exchange | Washington, DC
JONATHAN CHAIT apparently is unimpressed by citations to the work of personages such as Martin Feldstein, the president of the prestigious National Bureau of Economic Research and the George F. Baker Professor of Economics at Harvard University. Indeed, Mr Chait has a knack for drawing the bounds of intellectual respectability so tightly around himself that by late afternoon even his shadow falls outside the charmed circle. Even so, one must admit that Mr Feldstein's Clark medal and his endorsement by the New York Times for the job of Chairman of the Federal Reserve does leave one with a residue of suspicion. The Bank of Sweden has not bestowed upon him its coveted prize—though it's true he has been mentioned, specifically for his work on the theory of taxation. So let's not be too hasty to take him seriously.
Because Mr Chait is a self-avowed empiricist, perhaps he will favour this new NBER paper (free version here) by Christina and David Romer of the Univesity of California, Berkeley (despite somewhat embarrassing credentials, even slightly more lackluster than Mr Feldstein's). It is a dazzling empirical investigation of the effects of tax cuts and increases on economic output in the United States since the end of the second World War—one that significantly improves on the methodology of earlier attempts to estimate the effects of tax changes. They find that tax increases appear to have a very large, sustained, and highly significant negative impact on output. Since most of our exogenous tax changes are in fact reductions, the more intuitive way to express this result is that tax cuts have very large and persistent positive output effects.
The economists Romer looked at every tax change legislated at the national level since WWII. Impressively, they scoured “presidential speeches, executive-branch documents, and Congressional reports … to identify the size, timing, and principal motivation for all major postwar tax policy actions.” They then categorized each tax change based on whether or not it was intended as a forward-looking correction to the direction of the economy (they call these “endogenous” changes), or intended for other reasons, such as to reduce an inherited deficit or to boost long-run growth (the “exogenous” changes.) This allows them to tease out the output effects of tax cuts and tax increases set in place for different reasons.
Those interested in raising taxes, but unwilling to take seriously Martin Feldstein's estimate of the deadweight loss of tax increases, will need to grapple with Mr and Ms Romers' new findings. For example:
Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.
This is bad news for those with aspirations to higher levels of tax-financed spending. However, they find that not all tax hikes hurt the same. Tax increases specifically intended to offset budget deficits largely avoid the negative effects of other kinds of increases, in part by improving the climate of investor confidence.
In another fascinating new working paper on the “starve the beast” hypothesis (it is false, FYI), the Romer duo directly discuss the revenue effects of tax cuts. So, the question at the heart of Mr Chait's attack on supply side economics: do tax cuts pay for themselves?
[A]lthough a tax cut leads to a sharp fall in revenues in the short run, it does not have any clear impact on revenues at horizons beyond about two years. Second, roughly half of the tax cut is offset by legislated tax increases over the next several years. Taken together, these findings suggest that a substantial fraction of the rebound in revenues is the result of non-legislated changes. The key source of the non-legislated changes in revenues is almost certainly the effect of the tax cut on economic activity. In Romer and Romer (2007b), we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years. Since revenues are a function of income, this growth undoubtedly raises revenues.
So there you have it. Tax cuts don't exactly “pay for themselves”, but they also don't diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the original cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.
They do, however, add “an important caveat” to their “finding that tax cuts partially pay for themselves through more rapid growth”: the output effects of a tax cut may not last forever, in which case the cut could lead to shortfalls over the long run “in the absence of other legislative changes.”
The lesson, then, is that it is indeed irresponsible to think of a tax cut as a free lunch. If citizens wish to enjoy lower taxes, and do not wish to foist their debt on the next generation, they cannot avoid the responsibility of also cutting spending. This is how it should be. Truly “free” tax cuts make big government too much of a bargain. If you care about nothing more than getting out from under high tax rates, then self-funding tax cuts are a political dream come true: you don't have to ask anyone to give anything up. But if you worry about the intrusions, abuses, and injustices other than the confiscatory tax rates enabled by a massive state, you should not want too much slack in the relationship between the spending levels and tax rates.
For their part, empirically-minded champions of the welfare state like Mr Chait should be encouraged to discover that taxpayers seeking relief are not in fact the mortal enemy of government spending. The real nemesis of both government revenue and individual well-being is a slowed rate of economic growth, which, research shows, tax increases generally deliver.