Paul Krugman on the 2003 Tax Cut and the Recent Recovery

Mark Thoma has started an interesting discussion beginning with a Q&A with Paul Krugman:

Alan Gertler, Reno, Nev.: I’m a scientist, not an economist, so I’m fairly naive when it comes to what drives the economy. My question is this: Have the tax cuts stimulated the economy as claimed (which I don’t believe given the past cases of Reagan and Bush senior), or has it been the willingness of the government to continue massive spending by increasing our debt that has led to the growth of the economy?
Paul Krugman: It’s actually neither. About the Bush tax cuts: the tax cuts of 2001 evidently didn’t do the job; these days, the Bush people talk about the economy as if history began in the middle of 2003, after their SECOND wave of tax cuts. But while the economy did start growing, finally, in 2003, the growth wasn’t at all of the form you’d expect if tax cuts were responsible. The main tax cuts were on dividends and capital gains; supposedly this would make it easier for businesses to raise funds and invest. But business investment hasn’t been the main driver of growth; in fact, businesses have been sitting on huge piles of earnings, reluctant to invest. Instead, the big driver was housing construction and consumer spending.

I think Paul is generally right here but I had a wee bit of a problem with the last two sentences that was very ably addressed by a comment to Mark’s blog from Spencer. Mark had kindly provided an update with a chart of growth rate for non-residential investment, which my chart below does using annualized growth rates and includes real GDP growth, consumption growth, and residential investment growth. The simple empirical point is that non-residential investment growth has been strong since 2003. To which Spencer says:

In the major econometric models business investment is driven by corporate profits. Given the increase in profits we have seen this cycle the rebound in capital spending is disappointing. But it is like so many other things, what we are seeing is a fairly normal cyclical development and there is little evidence that the tax cuts made a significant difference. Another point that relates to this is to break capital spending down into information technology and software vs. all other, or traditional capital spending. If you look at real investment as a share of gdp what you find is that traditional capital spending is still about the same as it was in the late 1960s early 1970s. All the growth in capital spending since 1980 has been in the high technology sectors. If tax policy played a major role in the increase in capital spending shouldn’t it hav impacted all sectors. the fact that the growth has been contrasted in one sector implies that the driving force are factors within that sector — like falling prices — rather then economy wide factors like taxes.

Well said so all I had to add was:

If one only looked at investment spending since the 2003 tax law change … and if one was silly enough to do the Post Hoc Ergo Propter Hoc nonsense they teach over at the economics department of National Review University, one might go “wow – the tax cut worked”. But as you have so eloquently noted, one would have to look at a real model that would include various factors that would explain variation in investment demand. If the other factors fully explain the increase, then the marginal impact of this tax law change is from modest to zero – at least per our model.

Simply put – recessions come and go without tax cuts. Beyond that – classical economists have the long-term properties right: if you give people their money back so they can consume more but then do not cut government purchases, national savings decline.