2slugbaits Looks at Potential GDP

This one is by 2slugbaits…

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There’s been a lot of back-and-forth in comments to a number of posts here at Angry Bear, as well as elsewhere, about whether or not Bush’s tax cuts generated supply side economic growth. One approach is to look at changes in GDP growth rates; however, this isn’t necessarily ideal because it ignores what could be called an “identification” problem. Recall that the actual GDP that we observe is an equilibrium GDP and we cannot tell whether changes in GDP are due to shifts in the demand curve or shifts in the supply curve. By “equilibrium GDP” I mean that what we observe is the intersection point of the aggregated demand and aggregate supply curves; we do not directly observe shifts in the curves themselves, only the points at which demand equals supply.

Typically economists finesse this problem by assuming that the short run supply curve is nearly vertical, so any short run change in GDP is primarily due to a shift in aggregate demand. And a lot of the time this assumption of a nearly vertical supply curve is good enough. But I don’t think it’s good enough when the issue is whether or not Bush’s tax cuts yielded the intended effect of pushing out the supply curve. One way, albeit a rather crude way, to see whether or not Bush’s supply side tax cuts succeeded in pushing out the supply curve is to look at changes in the Federal Reserve’s estimate of potential GDP.

Potential GDP can be interpreted as a proxy for the non-inflationary aggregate supply curve. In other words, potential GDP tells us what we might expect the economy to produce assuming there is no slack in the economy and assuming that there is no excess aggregate demand. Over the last 30 years (1977 thru 2006) the average year-over-year change in potential GDP has been a smidgeon over 3% (see yellow line). Now if Bush’s supply side tax cuts had worked their magic as advertised, then we should have expected potential GDP to grow by at least this 3% benchmark.

But that’s not what actually happened. Instead we find that growth in potential GDP (see red line) consistently underperformed during the Bush years.

And oh by the way, potential GDP consistently overperformed during the Clinton years. As Gomer Pyle used to say, “Surprise, surprise, surprise!” Since we’re looking at potential GDP and not actual GDP all of the usual excuses for Bush’s sorry performance don’t hold water. It’s fair to ask just where are all the supply side effects of Bush’s tax cuts that we were promised? Inquiring minds want to know. Perhaps “Formerly Anonymous” can enlighten us.

Source: St. Louis Federal Reserve FRED database.

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This one was by 2slugbaits.