Another Supply-Side Claim: This is Not Einstein Economics

Perhaps macroeconomic professors should assign the latest from Cesar Conda & Ernest S. Christian (C&C) as reading material with an attached essay question designed to let their students find the various flaws in the argument:

The recipe for high GDP growth in the future is the same as it was in 2003-04, when the combination of lower tax rates and “bonus depreciation” caused a spurt in investment that helped lead the economy out of recession and toward its current strong standing … Standard neoclassical econometric models confirm what common sense and experience suggest: Replacing old-fashioned tax depreciation with immediate first-year expensing would add more than $200 billion to GDP, boost wage incomes, and add upwards of 750,000 jobs. Because the static revenue cost of first-year expensing quickly phases out after four years, it is also in the long term the cheapest, most bang-for-the-buck, and most growth-oriented tax change the Congress could make. When you use dynamic scoring that takes into account induced economic growth, first-year expensing costs nothing.

The essay question could be posed in terms of several aspects of C&C’s “argument”, which they are very unclear about. First, C&C do not tell us the size of the alleged direct impact on investment demand from this accelerated depreciation treatment for tax purposes. Secondly and more importantly, any neoclassical presumes full employment so an outward shift of the investment demand schedule would increase interest rates so as to reduce consumption demand. The net impact on investment demand must equal the decline in consumption and would tend to be much less than the direct impact. One would have to make assumptions to the elasticity of investment demand and the elasticity of saving (the supply curve if you will).

Even after one ascertained the (likely very small) net increase in annual investment spending, the premise of the neoclassical growth model is that output per capita grows very slowly over time when an economy engineers a capital deepening policy. The short-run impact on tax revenues would be negative, which begs the question – how is the government making up for the loss of tax revenues? Is there some offsetting reduction in government spending? If not, can we even be sure that national savings increases?

But I digress – so back to the dynamics. C&C are suggesting that this change in tax policy will (someday) increase output by $200 billion. Since that is clearly not the immediate impact, how many years will we have to wait to realize this alleged increase in output?

Bonus Question: Begin by taking a look at the fourth diagram of The Nation’s Fiscal Outlook, which is part of OMB’s Budget of the United States Government – Fiscal Year 2007, and then explain what Edward Lazear was trying to say (hint: I can’t explain it).

Added Bonus: Charles Wheelan mocks the Laffer Curve nonsense with this analogy:

Can’t Lose Weight by Eating More: Neither the Reagan nor the George W. Bush tax cuts were “self-financing,” as the Laffer disciples like to argue. According to The Economist – my former employer and no bastion of left-wing thought – the current Bush Administration’s top economist, Gregory Mankiw, estimated that decreasing taxes on labor would generate enough growth to recoup only about 17 cents for each lost dollar; a tax cut on capital is better, paying for more than half of itself. Still, the bottom line from the Bush Administration itself is that tax cuts reduce Uncle Sam’s take. So why does Laffer’s sketch on Dick Cheney’s cocktail napkin rank near the top of my list of bad economic ideas? Because, when applied to the U.S., it’s intellectually dishonest. The Laffer Curve offers the false promise that we can cut taxes without making any sacrifice on the spending side, and that’s simply not true. It’s the economic equivalent of arguing that you can lose weight by eating more … Whether it’s tax policy or dieting, you can’t have your cake and lose weight, too, which is why America currently has huge deficits and a lot of fat people.

Dr. Lazear flunks, while Mr. Wheelan aces the test!