The Neoconomists

Daniel Altman certainly has a catchy title to promote his upcoming book and I like the topic:

Hubbard and Lindsey saw cutting taxes on savings and wealth as a recipe for faster growth. Their plans were consistent with supply-side economics, which had dominated Republican policy for decades, since they targeted the economy’s long-run potential to grow… Wealthier people derive more of their income from returns on saving—both in dollar terms and as a proportion of income—than poor people do. When taxes on the return from savings suddenly disappear, the wealthy benefit the most. It may be that people who depend on their jobs for income will benefit, too, in the long run, thanks to an expanding economy and rising wages. But for several years, in all likelihood, the income gap will continue to widen.

Indeed, the plan outlined in Chapter 5 of the Economic Report of the President 2003 (ERP) will impose more of the tax burden on lower income groups even if President Bush pretends he is giving a tax cut to everyone (see this CBPP analysis). But I have two bones to pick what Mr. Altman’s May 10 Slate discussion – both bones related to my premise that he gives the Neoconomists (which may include Greg Mankiw) too much credit. The first bone is economics, while the second bone comes from a political reality with an economic consequence.

ERP’s discussion of the basic idea notes that eliminating taxes on capital income (akin to a Roth IRA) has similar ecnomics features as switching to a consumption tax (akin to a traditional IRA). The latter idea was the subject of “Simulating U.S. Tax Reform”by David Altig, Alan Auerbach, Laurence Kotlifkoff, Kent Summers, and Jan Walliser (NBER Working Paper # 6248, Oct. 1997, with an early version available here). This paper notes that even under ideal conditions that the increase in savings is modest, higher income per capita will require years of postponed consumption, and the winners (those who earned capital income) may reap more than 100% of the dynamic gains so that the losers (those who rely mainly on labor income) see their tax obligations rise by more than their pretax wages. So my first bone is how some Neoconomists sell this idea as something that will make everyone better off.

The second bone comes from how the Republican Party has taken the ideas of Hubbard and Mankiw and turned them into some dishonest free lunch political agenda. In order to sell tax cuts on capital income, George W. Bush has claimed he will give everyone their money back. A careful read of the Altig et al. paper will show an important modeling principle that some Neoconomists gloss over when they join the White House. If government spending is not restrained (never mind the fact that this White House has increased government spending), then a tax cut for one group requires tax increases for another if the principle of fiscal neutrality is to be perserved. And if the politicians do not have the discipline of fiscal neutrality, then giving people their money back so they can consume more necessarily means less saving and investment. We know this is true from the Reagan experiment with tax cuts, which led to less long-term growth.

When Dr. Hubbard was CEA chair, we did not hear much about crowding-out from him even though we know his academic writings admitted this link. Thankfully, Dr. Mankiw has forcefully noted this problem with Reaganomics in his academic writings and hopefully is advising President Bush that his fiscal irresponsibility will hurt long-term growth. Mr. Altman raises important issues and since he is free to write passages that are critical of the free-lunch version of supply-side or voodoo economics, let’s hope he does so when his book is published.