Tuesday, January 27, 2009

The Effects Of The 2003 Tax Cuts

Mark Thoma reports about a study about the 2003 Bush tax cuts from the Economic Policy Institute, which (much like Thoma) is leftist. The conclusion, not surprisingly, is that the tax cuts failed to generate growth

The argument that the tax cuts failed to generate growth is made on the basis of comparing actual job growth with an old forecast of job growth. Since actual job growth was lower than the forecast, this supposedly proves that it failed. Yet if you actually look at the chart all it proves is the uselessness of these forecasters since they predicted significant job growth months before the tax cuts, when in reality job growth was negative then.

First, it should be emphasized that economic theory cannot be proved or disproved on the basis of statistical data. Causal relationships are established through praxeological reasoning (for an example of this see here). And the main argument for catital gains and dividend tax cuts is that they will increase growth by improving the incentive for investments and also by allowing successful investors to keep more of their money and so increase their access to capital.

Still, empirical data can be useful in suggesting whether a particular factor had a significant impact in a particular time period and place. And what does the evidence suggest about the 2003 tax cuts? Not that they created some kind of permanent era of high growth as supply-siders at the time argued, nor that they had no or negative impact as leftists argue, but that they did provide a boost to economic growth which was significant, though not dramatic.

If we first of all look at jobs, J-O-B-S, that 3 letter word according to current vice president Joe Biden, it so happens that private sector employment (governments don't pay capital gains taxes and so shouldn't be included) fell from January 2001 to July 2003, which is to say it kept falling until a few months after the 2003 tax cuts.

A more specific way of testing the significance of the tax cuts would be to look at the item we would expect to be most affected by such cuts, namely business investments. Business investments fell sharply during the recession and kept falling even after it had ended, reaching a low in the first quarter of 2003, when the tax cuts were proposed, recovering after that.

Between the fourth quarter of 2001 and the first quarter of 2003, the recovery was to say the least sluggish with private sector employment falling and with GDP rising during those 5 quarters at an annual rate of just 1.7%. And moreover, in those 5 quarters the share of GDP going to government demand rose from 18.3% to 19.2%, while that going to housing rose from 4.7% to 5.0%. Excluding government and residential investments, GDP rose just 0.5% in those 5 quarters, or 0.4% at an annual rate. A lower rate of increase than the population growth of roughly 1%.

And even that 0.5% increase depended on an increase in consumption financed by rising house values, which enabled households to use their homes as ATMs, so to speak. In short, until mid-2003, economic activity outside of government and housing were contracting. But after that a significant recovery began, as private sctor employment finally starting to rise and with economic growth accelerating and that recovery were particularly strong in the sector that capital income taxation according to economic theory would have predicted to have the greatest impact, which is to say for business investments.

Also, the tax cuts seems to have boosted the dividend payout rate, which will have a positive effect on long term growth by encouraging redistribution of savings from older companies with little expansion possibilities to new companies.

In short: since the recovery significantly accelerated after the tax cuts and since the recovery was specifically concentrated in the sector where economic theory would predict it would be if it was caused by the tax cuts, it is clear that it is likely that they did in fact have a significant positive impact. Not as dramatically positive as some of the exaggerated assertions of certain supply-siders would suggest, but it is clearly significantly positive.


Anonymous Anonymous said...

Is the increase in government debt factored into these kinds of studies? The tax cuts are not free. They are usually funded by government debt which have to be paid back at a later date, plus interest. On top of this, government spending in the US is increasing almost every year. So on the short term you have tax cuts funded by dept and increased government spending, also funded by debt. All which increase short term GDP at the expense of long term prosperity.

4:38 PM  
Blogger stefankarlsson said...

Well, it's true that the increase in debt is a negative factor for the economy. But because of the tendency of foreign central banks to subsidize borrowing by the U.S. government, that is probably not a significant factor for America.

9:50 PM  
Anonymous Anonymous said...

Is it possible for you to elaborate further?

Getting a little off topic, lets say that the government borrows $1 million to create a contracted 1 job at $100,000 yearly pay for 10 years. Now this shows up as 1 net job creation and $1 million increase in GDP, since GDP does not take into account government debt. All employment and GDP stats would show this, a short term gain.

But the net effect of this -1 job for 10 years (lets assume this job is digging holes for sake of argument) and a net GDP increase of O minus the interest on the loan. Where would this show up?

11:50 PM  

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