Tax Cuts: Important Footnotes in Dynamic Scoring

by: Menzie Chinn

The White House today cited the 2006 Treasury Report in its "Pro Growth Tax Policy" information sheet. From the website:

3. Benefits of Making the Tax Cuts Permanent

The 2001 and 2003 tax cuts are currently scheduled to expire at the end of 2010. This scheduled expiration limits their beneficial impact on the economy, particularly with regard to decisions that pay off over long periods of time (for example, education or long-term investments). Making the tax cuts permanent can substantially improve economic performance. However, the long-run effects of extending the tax cuts depend on how the tax cuts are financed.

This point is illustrated in a 2006 study by the Treasury Department, which examines the long-run macroeconomic impact of making the tax cuts permanent. This study assumes that the tax cuts are financed by additional government borrowing through 2016. After 2016, two scenarios are considered. In the first scenario, government spending is reduced after 2016 to maintain a constant debt-to-GNP ratio. In the second scenario, income tax rates are raised across-the-board after 2016 to maintain a constant debt-to-GNP ratio. Treasury finds that in the first scenario, the capital stock increases by 2.3%, and long-run GNP increases by 0.7%. In terms of today's $14 trillion economy, this would amount to almost $100 billion per year in additional output, or $329 per capita. In the second scenario, long-run GNP falls by 0.9%.

Not all of the tax cuts have the same impact on output. Treasury also estimates that extending only the dividend and capital gains rate cuts would raise long-run GNP by 0.4% (assuming they are offset by spending reductions). If the top four ordinary income tax rates were made permanent as well, long-run output would increase by 1.1%. Adding the remaining tax cuts (including the child tax credit, marriage penalty relief, and the 10% bracket rate) would lower the impact on long-run output to 0.7%. These remaining provisions lower long-run output because they increase take-home pay without a reduction in marginal tax rates. The increase in take-home pay allows individuals to reduce their labor supply. [Emphasis added -- mdc]

Since the Bush Administration has done such an admirable job at restraining spending, I think it's useful to recall what I wrote about this report almost two years ago, in "A Dynamic Analysis of Permanent Extension of the President's Tax Relief":

The press account surrounding the Mid Session Review (MSR) (page 3-4) noted the preferred estimate of GNP response to the President's tax proposals: real GNP might be 0.7 percent higher than steady state baseline. The Treasury's Office of Tax Analysis has just released the underlying analysis.

There are, of course, a variety of estimates which differ depending upon assumptions regarding the time horizon, parameter values, and most importantly, whether the tax cuts are accomodated by reductions in future government spending or increases in future income taxes. The report admirably lays out the range of results for many configurations. Some are laid out in Table 3. The 0.7 percent deviation from baseline cited in the 2007 MSR is in the top right hand corner element, under "Financed by Decreasing Future Government Spending" (recent history has not been too supportive of this possibility, though). This estimate is for the case where capital gains and dividend tax rates are reduced, reduce top 4 ordinary rates, and make permanent 2001 and 2003 tax reductions.

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Table 3 from Office of Tax Analysis, "A Dynamic Analysis of Permanent Extension of the President's Tax Relief," U.S. Treasury, July 25, 2006.

Of course, the astute reader will note that if taxes are raised in the future to finance the tax cut, then GNP will eventually be 0.9 percent lower than steady state baseline. Table 4 indicates that -- for the future government spending reduction case -- low and high responsiveness parameters lead to increases in GNP of between 0.1 and 1.2 percent relative to initial steady state, respectively. 0.7 percent is approximately in the mid-point of the range bracketed by these two estimates. The future tax increase estimate is unchanged across parameter value configurations.s

Table 4 from Office of Tax Analysis, "A Dynamic Analysis of Permanent Extension of the President's Tax Relief," U.S. Treasury, July 25, 2006.

Note a similar diversity of effects is recounted in the CBO's analysis, How CBO Analyzed the Macroeconomic Effects of the President's Budget, July 2003, (Table 9), cited in my previous post on this subject. (By the way, the "Division on Dynamic Analysis" is in the President's budget proposal for FY2007.)...

Parting shot: It is important to understand that there is no welfare calculation undertaken, despite the fact that under certain conditions, GNP is higher than under baseline. That is because undertaking a welfare analysis would require taking a stand on the utility associated with government spending on goods and services. So even if one were to take the Treasury's high end estimate for the long run steady state effect, the answer to the question of whether tax cuts are desirable depends upon the utility associated with spending on civil servant wages, bridges, and body armor.

I say "Let Bush be Bush" and allow the legislation underpinning the Bush tax cuts (remember, the budget scoring running up to passage was based upon expiration of the tax cuts) be implemented as passed.