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The Devil Is In The Details
EARLY last month, without much fanfare, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates." At a modest seven pages, it didn't elicit the same sort of interest as the budget office's budgetary and economic outlooks. Yet it may be one of the most important government publications in years.
As Douglas J. Holtz-Eakin, the budget office's director, writes in a brief summary at the beginning of the paper, most predictions of the effects of tax-rate changes "do not include the budgetary impact of any possible macroeconomic effects of tax policies." In other words, the predictions don't take into account how tax cuts could affect the overall size of the economy. It is this omission - one often cited by proponents of tax cuts, especially in the White House - that the paper tries to correct.
The author of the analysis, Ben Page, estimates how an across-the-board cut in income tax rates could generate higher levels of economic activity, potentially replacing lost tax revenue. The theory behind these feedback effects is well worn: putting money back into taxpayers' pockets will let them spend more and save more, raising demand for goods and services and helping companies to invest for the future.
Mr. Page assumes that government spending will continue as planned for a decade after the tax cuts. He also creates different possibilities based on various assumptions about people's foresight, the mobility of capital and the ways in which the federal government might make up for the lost revenue when the decade is up - either by cutting spending or by raising taxes again. Finally, he compares the budget office's figures to those of two private forecasting firms, Global Insight and Macroeconomic Advisers.
Like many predictions in economics, Mr. Page's vary widely depending on his assumptions - this stuff is more like weather forecasting than Newtonian physics. But even within their range, the results answer the fundamental question posed by the Laffer Curve.
Arthur B. Laffer, an economist and sometime adviser to President Ronald Reagan, noted that when tax rates are zero, the government collects no revenue. He also noted that when tax rates are 100 percent, the same might be true: no one would work, he theorized. In between, along the curve he famously scribbled on a napkin, the amount of revenue collected first rises along with tax rates. Then, after a crucial point is passed, it falls back to zero, as it must under his theory.
One motivation for Mr. Reagan's tax cuts was a guess that the United States was on the right side of the curve - that is, that lowering rates would actually yield more tax revenue over all. Some recent statements by Joshua B. Bolten, President Bush's current budget director, seem to indicate that he still believes this to be true, though rates are much lower now than when Mr. Reagan took office in 1981.
In July 2003, Mr. Bolten said this at a press conference: "All economists, I think, will agree very strongly that when you reduce taxes, put more money back into the economy, that has a feedback effect in the economy that causes growth" and in turn "increases receipts." He added that he wanted "to see how much better the government's fiscal situation is as a result of the tax cuts."
The recent analysis by Mr. Page at the Congressional Budget Office dismisses the idea that tax cuts may actually improve the government's fiscal situation. Even in his most generous scenario, only 28 percent of lost tax revenue is recouped over a 10-year period. The United States, it seems, is firmly planted on the left side of the Laffer Curve.
Recent experience corroborates this prediction. In the second quarter of 2001, just before the first of President Bush's tax cuts took effect, federal receipts from personal taxes accounted for 10.3 percent of the economy. By the end of the post-recession slump, receipts had dropped to 6.4 percent. But in the third quarter of 2005, with the economy booming, they were still under 7.5 percent - an enormous difference. In dollar terms, federal receipts from personal income taxes, at $802 billion in 2004, are still lower than they were in 1998 ($826 billion) and much lower than in 2001 ($994 billion).
By itself, this reduced tax burden may seem like a good thing to people who don't buy Mr. Bolten's argument but still want a smaller government. But it's possible to view tax cuts' costs and benefits in more detail.
Shortfalls in revenue cause the government to borrow more, so money intended for other purposes must be paid as interest instead. Even in Mr. Page's most generous picture, the federal government would probably have to pay an extra $200 billion in interest over the decade covered by his analysis.
On the other hand, Mr. Page estimates that gross national product would be an average of about 1 percent higher, adjusted for prices, as a result of the 10 percent cut in tax rates. Based on the August forecast by the budget office, that extra income would come to slightly less than $1.5 trillion in today's dollars. In Mr. Page's analysis, consumers would also pay about $900 billion less in taxes. Over all, they'd have up to $2.4 trillion more to spend during the decade he analyzed.
THE tax cuts' benefits would be whatever pleasures that individuals could attain with that money. The initial costs would be the absence of whatever useful things the government would have done with the $200 billion it had to pay in interest. The later costs would be the pleasures or useful things the nation would have to forgo in the future, when it was time to pay its debts.
For many people, this may sound like a slam dunk, especially if they don't care what happens after the next decade. But keep going in this direction, and pretty soon the federal government would be collecting no taxes and trying to borrow enough money to cover its entire budget. It's doubtful that many people would want to lend to a government with no source of revenue for 10 years.
Call it the Altman Curve: the total amount that people will actually lend you rises with the amount you plan to borrow, until you reach a crucial point, after which it falls to zero. The United States is now on the left side of the curve. If Congress keeps cutting taxes by more than it cuts spending, the nation will eventually move to the right side, which, of course, is the wrong side.
Posted: 01-01-06
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