Saturday, July 17, 2010

Do tax cuts pay for themselves?

One of the most fundamental tenets of supply-side economics is the entrenched belief that tax cuts pay for themselves. This ideological belief, which is unsupported by empirical facts, forms the cornerstone of conservatives' advocacy of tax cuts to boost economic growth. Paul Krugman has three excellent graphics that are self-explanatory.

Despite the higher tax rates, the Carter era saw a steady growth in revenues. In contrast, the Reagan era, with its tax cuts, saw permanent reduction in revenues relative to what they would otherwise have been. As Krugman writes, the Reagan tax cuts saw "a drop in revenues, then a resumption of growth, but no return to the previous trend". Below is the real federal revenue, in 2005 dollars, from 1970 to 1990.

The Clinton and Bush administrations were two two-term administrations, one of which raised taxes, while the other cut them. But the graphics below - of federal revenues and total non-farm payrolls for the respective periods - do not lend support to the claims of supply-siders. In fact, despite the tax cuts, the Bush era federal revenues and employment rate never touched the Clinton period growth trends (despite its tax increases).

This explains why Paul Samuelson described such reasoning "snake-oil economics"!

Update 1 (27/7/2010)

Excellent post in FT by Martin Wolf about the political psychology behind supply-side economics.

Update 2 (1/9/2010)
David Leonhardt writes, "... even Ronald Reagan’s much-lauded 1981 tax cut doesn’t appear to have worked. After he signed it, the economy lost jobs for 16 straight months. It didn’t start gaining jobs until after he had raised taxes, to reduce the deficit, in late 1982."

1 comment:

Robin said...

Top tax rate when Reagan took office was 70%, still 50% in 1986, but only 39.6% under Clinton. Top capital gains tax when Reagan left office was 28%, but only 20% after 1997 under Clinton. In what sense does this show lower tax rates don't matter?

The second graph shows rapid real revenue growth after then 1991 recession but conceals rapid real revenue growth after the 1980-82 recession.