Dynamic Analysis: Tax Cuts and Crowding-Out

Given how late am I to the party in terms of discussing A Dynamic Analysis of Permanent Extension of the President’s Tax Relief, I’m thankful that David Altig summarized the economist blog discussion on this dynamic scoring debate. David, however, dumped on my favorite summary, which was provided by Brad DeLong:

What proportion of students will be able to follow the syllogism?

• Tax relief is good for growth only if the tax reductions are financed by spending restraint.

• The Bush tax reductions have been financed not by spending restraint but by borrowing.


• The Bush tax reductions have been bad for growth.

So what is David’s rebuttal?

I hope the answer is none, because one of the premises is irrelevant. The question is not have the tax cuts been financed by spending cuts, but rather will they be financed by spending cuts. Brad’s expectation may be reasonable given the politics of the situation, but you obviously cannot draw conclusions by assuming a condition that has yet to be determined.

Actually, David may have a point – and in fact, his point is critical to the premise that tax cuts might encourage a small bit of extra growth once one actually digests the incredible bait and switch in this Treasury document.

For example, this document vacillates between the two contradictory explanations for the Bush tax cuts as it says on the one hand we needed the tax cuts to spur more consumption (= less savings) in order to generate an increase in Keynesian aggregate demand to rescue us from that recession, while on the other hand, it claims the tax cuts increased national savings. OK, Lawrence Lindsey played Keynesian in 2001, while Glenn Hubbard played classical economists – and the political hacks in the White House refused to recognize that the President’s two economic advisors were contradicting each other.

But let’s concede that this document says over and over that the key is future reductions in government spending as it admits that if these tax cuts are really tax shifts that will necessitate future tax increases, then they will lead to less growth in the long-run. Page 10 even utters the word foreign to the free-lunch GOP camp – CROWDING-OUT. I only wished this document would have conceded the obvious fact that the sum of consumption and government purchases as shares of national income in 2005 was higher than it was in 2000.

But let’s go back to page 5 for the ultimate bait and switch. As it notes its assumption of a constant long-run debt to GDP ratio (I guess the authors have not noticed the increase in this ratio since George W. Bush took office), it talks about maintaining the tax rates projected for 2011 to 2016 under current law. Excuse me – but current law has most of the Bush tax cuts expiring by 2010. So, the document assumes we return to Clinton style tax policy. And then it says making the Bush tax cuts permanent is pro-growth without telling us where we will get all those massive reductions in government spending in the future?

David says this is a teachable moment. He’s right. We should teach our students to read such documents very carefully.

Update: Brad replies to David:

It’s possible that there are huge spending cuts relative to GDP in our future. It’s not terribly likely. If I were Macroblog, I would say, instead, that the Bush tax cuts are good for growth because in response to the tax-cut magic the Growth Fairy will appear, wave her wand, and instantaneously boost labor productivity by 5%. That seems more likely than Macroblog’s scenario. There is a serious issue here: When one does policy evaluation of the proposals of an administration, does one evaluate the effects of the policies that the administration has proposed? Or does one evaluate the effects of the policies that the administration has proposed plus policies that the administration has not proposed, shows no inclination to propose, but that one wishes it would propose?

Didn’t we go through this a generation ago? Pro-growth proponents of Reagan’s 1981 tax cut – you know, the one founded on “work, save and invest” – may have hoped that Congress would slash spending. It did not happen with the result being that national savings fell. What makes anyone think this round will be any different?