TAX CUTS: MYTHS AND REALITIES
Since 2001, the Administration and Congress have enacted a wide array of tax cuts, including reductions in individual income tax rates, repeal of the estate tax, and reductions in capital gains and dividend taxes. Nearly all of these tax cuts are scheduled to expire by the end of 2010. Making them permanent would cost about $3.5 trillion over the next decade (when the cost of additional interest on the federal debt is included). (http://www.cbpp.org/1-31-07tax.htm)
Because important decisions about these tax policies must be made in the next few years, it is essential to understand their effects on deficits, the economy, and the distribution of income. Supporters of the tax cuts have sometimes sought to bolster their case by understating the tax cuts’ costs, overstating their economic effects, or minimizing their regressivity. Here, we address some of the myths heard most frequently in recent tax-cut debates. (For a discussion of myths specific to the estate tax debate, see cbpp.org. For a discussion of issues surrounding the Alternative Minimum Tax, see cbpp.org
Tax Cuts and Deficits
Congressional Budget Office data show that the tax cuts have been the single largest contributor to the reemergence of substantial budget deficits in recent years. Legislation enacted since 2001 has added about $2.3 trillion to deficits between 2001 and 2006, with half of this deterioration in the budget due to the tax cuts (about a third was due to increases in security spending, and about a sixth to increases in domestic spending). Yet the President and some Congressional leaders decline to acknowledge the tax cuts’ role in the nation’s budget problems, falling back instead on the discredited nostrum that tax cuts “pay for themselves.”
Myth 1: Tax cuts “pay for themselves.”
“You cut taxes and the tax revenues increase.” — President Bush, February 8, 2006
“You have to pay for these tax cuts twice under these pay-go rules if you apply them, because these tax cuts pay for themselves.” — Senate Budget Committee Chair Judd Gregg, March 9, 2006
Reality: A study by the President’s own Treasury Department recently confirmed the common-sense view shared by economists across the political spectrum: cutting taxes decreases revenues.
Proponents of tax cuts often claim that “dynamic scoring” — that is, considering tax cuts’ economic effects when calculating their costs — would substantially lower the estimated cost of tax reductions, or even shrink it to zero. The argument is that tax cuts dramatically boost economic growth, which in turn boosts revenues by enough to offset the revenue loss from the tax cuts.
But when Treasury Department staff simulated the economic effects of extending the President’s tax cuts, they found that, at best, the tax cuts would have modest positive effects on the economy; these economic gains would pay for at most 10 percent of the tax cuts’ total cost. Under other assumptions, Treasury found that the tax cuts could slightly decrease long-run economic growth, in which case they would cost modestly more than otherwise expected. (http://www.cbpp.org/7-27-06tax.htm)
The claim that tax cuts pay for themselves had already been rejected by the Administration’s own leading economists. Edward Lazear, the current chair of President’s Bush’s Council of Economic Advisers, has stated, “I certainly would not claim that tax cuts pay for themselves.” N. Gregory Mankiw, President’s Bush’s former CEA chair and a well-known Harvard economics professor, has written that there is “no credible evidence” that “tax revenues… rise in the face of lower tax rates.” Mankiw compared an economist who says that tax cuts pay for themselves to a “snake oil salesman trying to sell a miracle cure.”
The claim that tax cuts pay for themselves also is contradicted by the historical record. In 1981, Congress substantially lowered marginal income-tax rates on the well off, while in 1990 and 1993, Congress raised marginal rates on the well off. The economy grew at virtually the same rate in the 1990s as in the 1980s (adjusted for inflation and population growth), but revenues grew about twice as fast in the 1990s, when tax rates were increased, as in the 1980s, when tax rates were cut. During the current recovery (with its tax cuts), the economy has grown at about the same pace as during the equivalent period of the 1990s business cycle, but revenues have grown far more slowly. (http://www.cbpp.org/3-8-06tax.htm)
Myth 2: Even if the tax cuts reduced revenues initially, they boosted revenues and lowered deficits in 2005 and 2006.
“Some in Washington say we had to choose between cutting taxes and cutting the deficit… Today’s numbers [the updated 2006 budget projections] show that that was a false choice. The economic growth fueled by tax relief has helped send our tax revenues soaring.” — President Bush, July 11, 2006
Reality: Strong revenue growth in 2005 and 2006 has not made up for extraordinarily weak revenue growth over the previous few years.
When discussing revenue growth since the enactment of the tax cuts, Administration officials typically focus only on revenue growth since 2004. This provides a convenient starting point for their arguments, as it sets a very low bar. In 2001, 2002, and 2003, revenues fell in nominal terms (i.e. without adjusting for inflation) for three straight years, the first time this has occurred since before World War II. Measured as a share of the economy, revenues in 2004 were at their lowest level since 1959. Given this historically low starting point, it is not surprising that revenues have recovered since then. Supporters of the tax cuts selectively cite revenue growth over just the past two years to argue that the tax cuts are fueling increases in revenues.
Total Real Per-Capita Revenue Growth in 22 Quarters after the Last Business Cycle Peak
Current Business Cycle
-0.4%
Average for All Previous Post-World War II Business Cycles
9.8%
1990s Business Cycle (Following Tax Increases)
10.7%
Even taking into account the growth in revenues in fiscal year 2006, total revenue growth over the current business cycle as a whole has still been negative, after adjusting for inflation and population growth. (The current business cycle began in March 2001, when the last business cycle hit its peak and thereby came to an end.) In other words, the current revenue “surge” is merely restoring revenues to where they were half a decade ago. In contrast, five and a half years after the peak of previous post-World War II business cycles, real per-capita revenues had increased by an average of 10 percent, and in the 1990s, real per-capita revenues were up 11 percent (see Table 1). Revenues in 2006 were still more than $200 billion short of where they would have been had they grown at the rates typical in other recoveries. (http://www.cbpp.org/policy-points1-23-07.htm)
Further, while the Administration has credited the tax cuts with the drop in the projected fiscal year 2006 deficit to “only” $248 billion, this year’s budget would be essentially balanced were it not for the tax cuts. Based on Joint Committee on Taxation estimates, the total cost of tax cuts enacted since January 2001 is $251 billion in 2006, taking into account the increased interest costs on the debt that have resulted from the deficit financing of the tax cuts. This means that even with the spending for the wars in Iraq and Afghanistan and the response to Hurricane Katrina, the federal budget would essentially be in balance now if the tax cuts had not been enacted, or if their costs had been offset. While supporters of these tax cuts claim that their positive economic effects have lowered their cost, the non-partisan Congressional Research Service found in a September, 2006 report that “at the current time, as the stimulus effects have faded and the effects of added debt service has grown, the 2001-2004 tax cuts are probably costing more than expected.” (http://www.cbpp.org/8-17-06bud.htm)
Looking out over the next several decades, when deficits are projected to be far larger (because of the impact on the budget of the retirement of the baby boomers and the continued rise in health care costs), the tax cuts, if extended, will still be a major contributor to the nation’s fiscal problems. (http://www.cbpp.org/1-29-07bud.htm) To put the long-run cost of the tax cuts in perspective, the 75-year Social Security shortfall, about which the President and Congressional leaders have expressed grave concern, is about one-third the cost of the tax cuts over the same period. (http://www.cbpp.org/5-1-06socsec.htm)
Tax Cuts and the Economy
A consistent finding in the academic literature about the effects of tax cuts on the economy is that these effects are typically modest. In the short run, well-designed tax cuts can help to boost an economy that is in a recession. In the longer run, well-designed tax cuts can have a modest positive impact if they are fully paid for. For example, the recent Treasury analysis found that if the President’s tax cuts were made permanent and the costs of the tax cuts were paid for by reductions in programs, economic growth would increase by a few hundredths of one percentage point annually. Meanwhile, studies by economists at the Joint Committee on Taxation, the Congressional Budget Office, the Brookings Institution, and elsewhere have found that if tax cuts are not paid for with spending reductions, they are likely to have modest negative effects on the economy over time, because of the negative effects of the increased deficits. Tax-cut proponents often claim that the economy will be badly damaged if the tax cuts are not extended; these claims are without foundation.
Myth 3: The current economic expansion has been strong as a result of the tax cuts.
“The main reason for our growing economy is that we cut taxes and left more money in the hands of families and workers and small business owners.” — President Bush, November 4, 2006
Reality: The current economic expansion has been sub-par overall, and job and wage growth have been anemic.
Members of the Administration routinely tout statistics regarding recent economic growth, then credit the President’s tax cuts with what they portray as a stellar economic performance (see Figure 2). But as a general rule, it is difficult or impossible to infer the effect of a given tax cut from looking at a few years of economic data, simply because so many factors other than tax policy influence the economy. What the data do show clearly is that, despite major tax cuts in 2001, 2002, 2003, 2004, and 2006, the economy’s recent performance has been far from stellar.
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