Stumbling Blocks Between Tax Cuts and Economic Growth

A few years ago, Bill Gale and I wrote a paper about the relationship between tax reform -- defined generally as lowering marginal tax rates and broadening the base on which those taxes are levied -- and economic growth, anticipating that there were likely to be claims in the near future that such tax changes would lead to economic growth. That future has arrived with the long-anticipated Republican tax plan unveiled last week.

The following quote from that paper appeared in the Christian Science Monitor last week:

Well-designed tax policies have the potential to raise economic growth. But there are many stumbling blocks along the way and certainly no guarantee that all tax changes will improve economic performance.

What are those stumbling blocks? The remainder of the paragraph from the paper gives some indication:

Given the various channels through which tax policy affects growth, a tax change will be more growth-inducing to the extent that it involves (i) large positive incentive (substitution) effects that encourage work, saving, and investment; (ii) small or negative income effects, including a careful targeting of tax cuts toward new economic activity, rather than providing windfall gains for previous activities; (iii) reductions in distortions across economic sectors and across different types of income and consumption; and (iv) minimal increases in, or reductions in, the budget deficit. 

The rationale for why there could be a link between tax reform and economic growth starts with the substitution effect, which in this case promotes economic activity because households get to keep more of the income they generate through that activity. Against this boost in economic activity are three countervailing forces:

1) The income effect, whereby the lower tax rate generates more after-tax income for a given amount of economic activity, encouraging higher consumption of all goods, including leisure. That reduces work. There is no guarantee that the substitution effect is greater than the income effect. As we note in the paper, this is more likely to happen when only the marginal tax rate changes. But if the whole schedule of tax rates is lower, then inframarginal tax rates are changing as well, and income effects are thus likely to be much larger.

2) The need to pay for the revenue loss associated with the tax cuts. This is the base broadening aspect of tax reform. In the Republican proposal, for example, the cap for the value of a mortgage on which interest can be deducted is lowered from $1 million to $500,000. This means lower deductions and thus some gain in tax revenues. Fine. But it also means less economic activity in housing, since we can expect fewer large homes or homes in pricey areas to be built. If lower marginal tax rates on work are thought to encourage work, then why would higher tax costs of housing not discourage housing? While discouraging further housing investment might be fine as public policy, the loss of economic activity in the housing sector is a drag on economic growth.

3) Alternatively, if the revenue loss is not made up contemporaneously through higher taxes elsewhere, then the horizon over which the economic growth is measured needs to include all of the time over which the higher debt due to the widening of the budget deficit is serviced. Servicing that incremental debt reduces economic activity elsewhere in the economy. If the tax revenue is not made up elsewhere, then what we have is not economic growth, but a shifting of economic activity to the present from the future.

So those are the stumbling blocks -- income effects, higher taxes due to base-broadening, and the costs of servicing incremental debt.

I expect to blog again soon about some other aspects of tax reform, focusing on income transfers.