The Rational Argumentator

A Journal for Western Man

Do Taxes Reduce Growth or Increase It?

Here's a tricky question: if the tax increases proposed in the Obama budget are passed, what would be the effect on economic growth?  It's a standard line with Republicans these days that higher taxes hamper economic growth.  The logic is simple: higher rates reduce the incentive to invest, and less investment means lower growth.  However, this analysis looks at only one aspect of taxes and ignores what happens if taxes are not raised.
 
The federal government currently runs a budget deficit, and finances it with borrowing.  On our current trajectory, we have deficits "as far as the eye can see," and growing interest costs.  Expanding government debt, and the costs of servicing it, also reduce investment and growth.
 
With that in mind, there's reason for uncertainty about the effects of tax increases.  I'll not attempt to analyze all of the Obama tax ideas, but let's look at some of the more straightforward ones.  The first tax increases that come to mind would be expiration of the two "Bush" tax bills and the increasing number of people caught in the AMT.  The Congressional Budget Office (CBO) has studied the likely course of federal budgets over time, calculating the size of deficits by assuming normal economic growth and looking at what happens, given commitments that have already been made for entitlements: Social Security, Medicare, and Medicaid.  The CBO's "baseline projection" for federal assumes that these tax increases occur, and that discretionary spending remains constant (constant level, not constant share of GDP), and no new entitlements.  In this scenario, deficits explode and debt to GDP ratio goes to record levels, passing 100% or so by mid-century.  Annual payments for entitlements and interest exceed revenues before too long after that.

In the more realistic "alternative scenario," CBO assumes these tax increases don't occur, and discretionary spending is assumed to stay a constant share of GDP.  In that scenario, the U.S. reaches unsustainable levels of debt even sooner than under the baseline scenario.  Either way, the United States is on the road to exploding deficits and a sovereign debt crisis.

So lower tax rates might stimulate growth compared to higher rates, but also increase the deficit.  What are the tradeoffs? Some questions about magnitudes are in order:

1. What is the Rate Elasticity of Revenue (or whatever it’s called) for the top marginal rates?  I suppose that we are currently on the positive side of the Laffer curve, so raising rates would raise revenue, and decrease deficits.

2. Assume that the deadweight loss of the higher rates also means lower immediate growth.  Would the reduction in deficits be sufficient to increase growth over the longer run?  The CBO estimates assume that exploding deficits do not have any effect on interest rates or growth, which we (and CBO) knows isn't true.  (CBO is bound by law to make this assumption in the baseline scenario.)

3. How much reduction in spending is possible -- both discretionary and non-discretionary?  Looking at tax policy in isolation doesn't make sense.  (E.g. when we're running deficits, a tax "cut" not accompanied by a spending cut is simply a transfer of the tax burden to whomever is shouldering the costs of borrowing.)
 
No answers here now, but these are important questions, and anyone purporting to know what to do about the federal deficits ought to be able to answer them.  It should be clear, too, that there's no easy answer to the deficit dilemma, and no clear relation between marginal changes in tax rates and economic growth.
 
Postscript: After writing this up, I noticed an interesting graph on Baseline Scenario that addresses this issue -- worth a look.

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