Growth and the Bush Tax Cuts

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David Leonhardt notes that evidence of the Bush tax cuts’ beneficial impact on growth is difficult to find:

Is there good evidence the tax cuts persuaded more people to join the work force (because they would be able to keep more of their income)? Not really. The labor-force participation rate fell in the years after 2001 and has never again approached its record in the year 2000.

Is there evidence that the tax cuts led to a lot of entrepreneurship and innovation? Again, no. The rate at which start-up businesses created jobs fell during the past decade.

The theory for why tax cuts should create growth and jobs is a strong one. When people are allowed to keep more of each dollar they earn, they are likely to work longer and harder. The uncertainty is the magnitude of this effect. With everything else that’s happening in a $15 trillion economy, how large of an effect on growth do tax cuts have?

This is an under-discussed issue but I think it has a relatively clear answer. The theoretical case for the supply-side growth-enhancing impact of tax cuts requires the cuts to be offset with reduced spending. You can see this most clearly if you think about the savings and investment channel. Lower taxes on households will increase household consumption and increase household savings. Insofar as the reduced taxation is concentrated on high-income households, the balance will be tilted toward increasing savings. But if the tax cut is financed by government borrowing rather than reduced spending over 100 percent of the effect will be offset by the borrowing. So nothing is achieved.

On the labor market it’s similar. Someone like Greg Mankiw or myself who has the opportunity to do freelance writing work really should respond to transient tax cuts with increased output. But given that the tax cuts will be transient, our current increased output will be reduced in the future with reduced output with taxes are raised. The money has to be repaid, after all, out of tax revenue and with interest. And rational agents making long- or medium-term plans about their own human capital and life decisions should be basically indifferent to transient changes in tax rates. The issue is the long-term tax burden which is determined by the level of spending.

Tax cuts, whether “permanent” or “temporary” are in fact temporary if they’re offset by borrowing money. And as Cato’s Daniel Mitchell points out “temporary tax cuts have very little pro-growth impact.” And not only were the Bush tax cuts not offset by spending reductions, they weren’t even permanent in a statutory sense! According to the very economic theory that explains why lower taxes can boost growth, the Bush tax cuts should have done nothing to boost growth. So it’s no surprise that nobody can find empirical confirmation of the pro-growth impact.