Tax Policy, GDP Growth, and the Deficit

I’ve been looking for an excuse to post this diagram of real Federal tax revenues (excluding payroll contributions) and Kash’s post “The Budget Deficit in Context” and a few other posts on this topic provide that excuse. I guess the standard supply-side reply to Kash’s noting that revenues as a percent of GDP have fallen dramatically would run something along the lines of the latest from Jerry Bowyer:

The revision also raises the average for the last 10 quarters to 4.1 percent, which, as the chart above shows, bests the 3.6 percent mark set over President Clinton’s term. Why do we begin counting 10 quarters ago? Because while Bush’s overall GDP average remains tempered by the anemic economy he inherited, it has grown by leaps and bounds since he signed his full tax cut (the so-called “tax cut for the rich”) into law.

We have heard a lot of this rhetoric lately. AB, however, notes that the economy over the past five years has not faired all that well. Simply put – some of the Bush supporters voted for the 2001 tax cut before they voted against it. AB reader Tom put it well – the growth over the past 10 quarters is nothing more than a business cycle recovery from the very weak growth of the prior 9 quarters. If real GDP grows by 1% (4% per annum) during the last quarter of 2005, the five-year increase over 2000QIV will have been only 14.5%. So I was wondering how this compares to other five-year periods:

1971-1975: 17.0%
1976-1980: 18.3%
1981-1985: 18.2%
1986-1990: 15.1%
1991-1995: 14.6%
1996-2000: 21.9%
2001-2005: 14.5%

Once one adjusts for business cycle effects, the effect of neither the Bush43 nor the Reagan fiscal stimulus on long-term growth does not appear to be as rosy as the National Review or Greg Mankiw would have us believe.

In the past, I have been critical of supply siders who say that tax cuts generate so much growth as to increase tax revenue. That is different than being critical of tax cuts. I believe that tax cuts increase growth and, therefore, are partly self-financing. I think it is overoptimistic to say they are fully self-financing. That is why spending restraint must go hand in hand with tax cuts.

To be fair to Dr. Mankiw, he does add the caveat that tax cuts must be accompanied by spending cuts if they are to have positive supply-side effects. Otherwise, the fiscal stimulus will crowd out investment. But returning to Kash’s post – note that neither the Reagan nor the Bush43 tax cuts were accompanied by spending cuts of any appreciable amount.

Finally, we should note that decade-by-decade increases in real Federal tax revenues:

1971-1980: 39.4%
1981-1990: 15.7%
1991-2000: 67.5%

(Here is where I should answer Ken’s question about my graph. Blue line is actual data and pink line shows trend for each decade. Note that this trend is quite steep for 1991 to 2000 – and I took the liberty of just letting this trend extend through 2005 to show how far current tax revenues are below the 1990’s trend.)

It does seem that the promises of a free lunch from certain supply-side types are not supported by the historical evidence.