Small Responders vs. Big Ones

April 18th, 2012 at 5:10 pm

In the world of national security, you’ve got first responders.  In economics, you’ve got big responders and small responders.

Let me explain.

Big responders walk around carrying big elasticities in their pockets.  Tweak a tax rate, in particular, and large changes will occur to growth, jobs, and revenues.  Same with a minimum wage—raise it a few cents, and everybody gets fired.

Small responders see things differently.  We look at the historical record and generally—not always—can’t find those humongous responses in the behavior of economic actors (aka “people”).  For us, a change in Y often leads to a change in X, but a) not always, and b) it’s the magnitude that matters, not just the sign.

More precisely, it’s not just the magnitude that matters; it’s the real economic outcomes.  A tax change might lead people to change the timing of when they realize capital gains or change their tax sheltering regime.  But, like I said, if it doesn’t show up in growth, investment, jobs, paychecks, revenues—stuff like that—it’s a lot less compelling as public policy.

Again, taxes and minimum wage changes offer great examples.  The empirical record supports the smallies, not the biggies.

So why am I raising all this?  Because I just perused this interesting testimony by tax economist Jane Gravelle on how changes in corporate taxation might affect growth, jobs, wages, and government revenue.  It’s actually surprisingly readable and mercifully short, so I encourage you to take a look.

Her key estimate is “that a ten percentage point reduction in the corporate tax rate (from 35% to 25%) would induce an increase in U.S. output of less than 2/10 of 1%.”

That’s an awfully small output response for such a large change in the tax rate.  And if you’ve been ensconsed in this debate as I have, it’s a tiny fraction of what you hear from the advocates of cutting the corporate rate.

Moreover, such a large reduction in the corporate tax rate would lose over $100 billion a year.

Wait a minute…did I not just claim to be a small responder?  That sounds like a lot of revenue.  Ah, but this is not a behavioral response—it’s accounting based on expected revenue flows when you cut a tax rate by almost a third.

But wouldn’t that new output induced by the big corporate tax cut offset the revenue loss?  Um…it’s but a 0.2% increase in output…so, no.  Gravelle estimates that the output gain would offset 5-6% of the lost revenue.

One final thought here: Armed with a) a realistic view of the magnitude of responses to changes in tax rates, b) the recognition that we need revenues, and c) a dose of political reality about how much you could realistically broaden the base by shutting down loopholes, you end up a lot less wound up about the potential for major tax reform that cuts the rates and broadens the base.

Here’s Gravelle responding to a question from a Senator about how she would reform taxes if she were queen for a day:

I probably wouldn’t do a lot different from what we have now. CRS just released a report where we look specifically at base broadening and individual income tax reform, and tax reform and fundamental tax reform looks a lot easier when you talk about it in generalities than when you talk about it in specifics.

So for example, ideas such as eliminating tax expenditures by taxing Medicare, which would be disastrous for low-income people, by taxing capital gains at death, by taxing pensions… we have a list of the top twenty tax expenditures, and when you start looking at those you see that they are very hard…

With respect to the corporate tax, I just think we need to be careful because the corporate tax doesn’t have as many tax expenditures and if you do something about depreciation or things like that, you’re actually going to increase the cost of capital on a revenue-neutral change. Also, I found that if you eliminated every tax expenditure you could only reduce the corporate tax by about 5 percentage points. So I think you have to look very realistically at exactly what you have to do with tax reform before you decide which way to go.

Don’t get me wrong.  There’s a lot we should fix within our tax code—if I were queen king, I’d phase out the preferences for capital income over wage income, and for debt financing over equity.  But I’m increasingly convinced that most people’s ideas of major tax reform are not targeted at greater simplicity, fairness, and revenues.  They’re targeted at cuts that will release all kinds of giant, wonderful responses.

Except for they won’t.

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6 comments in reply to "Small Responders vs. Big Ones"

  1. Daniel Kuehn says:

    I agree very strongly, and I worked out some of the reasons why people make this mistake here:

  2. Brad says:

    I’ve read various arguments from a progressive perspective for eliminating corporate taxes entirely and making up the revenue with tax increases in other areas. Would love to hear your thoughts on this.

  3. NP says:

    I think Gravelle’s conclusion is wrong because there is a lot that needs to be changed about the tax code. For one, the rates on high income earners needs to be raised significantly – you have talked about this a lot. This is a small responder conclusion, i.e. taxing the rich more will generate significantly more revenues (and have great societal benefits) but not really change their behavior that much – in terms of hiding income etc. (anymore than they are already doing).

  4. Tyler says:

    Tax increases reduce the deficit, which is exactly what we should not be doing right now.

    “In short, those who want to cut the deficit now are lobbying for fewer jobs and higher unemployment.” – Dean Baker

    “Look after the unemployment, and the budget will look after itself.” – John Maynard Keynes, in a radio interview in 1933 (Reference: Collected Writings of John Maynard Keynes, Volume XXI, page 150)

  5. marcel says:

    But, but, but…THE SKY IS FALLING!

    Rather than big vs. small responders, you might put this as a contrast between Chicken Little on the one hand and … hmmm, I cannot figure out who told CL to chill. Maybe D. McCloskey

    (If the link gets trashed when I post it, I linked McCloskey’s name to this:

  6. Master Jared Bernstein: Tax Cuts and Job Growth: They’re Just Not That Into Each Other says:

    [...] That doesn’t mean measures like the payroll tax holiday are useless. For one, by increasing the after-tax wage, they put more money in people’s pockets, and that in-and-of-itself creates more demand. Also, when the economy turns up and demand begins to come back, a cut in the tax wedge can give cautious employers a nudge to pull some future hires forward into the present. Master But as Bartlett shows, there’s no correlation between the tax wedge and employment rates across countries. The figure shows the scatterplot. There’s a slope there but it’s nowhere close to significant and the R-square is 0.005, meaning there’s no cross-country correlation between the magnitude of the tax wedge and the employment rate. A better test would be changes across time, and such panel data analyses find a bit more than the cross-sectional view. But not much. Here again, small responders win. [...]

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