Tax Attacks

August 22nd, 2012 at 9:11 am

Just a small dose of microeconomics to start out the day here.  I promise it will go down like butta.

There’s this dustup going on between one of Gov Romney’s economic advisors and the WaPo editorial board.  The gist is one I’ve talked about—and even vblogged on—before: as re the tax cuts for the wealthy in the Romney plan, there is not enough revenue in the base broadeners to offset the losses from the rate cuts.

Predictably, the advocates of such cuts invoke supply-side growth effects that will be large enough to more than make up the difference: if you lower marginal tax rates thus raising after-tax income at the margin, people will work harder (longer, really), invest more, etc.  As OTE’ers know, there’s no theory that’s so prevalent yet so wrong, but there it is.

However, even on theoretical terms, invoking supply-side is not a sufficient response because it invokes only the “substitution effect,” when all that base-broadening pushes the other way—toward less labor supply—through the “income effect.”

As economist Lawrence Koltikoff points out this AM, “[t]he Romney tax plan has relatively minor incentive effects and the income effects of its base broadening go in the wrong direction.”

Now that I’ve laid out the flaws in the theory, I sure the Romney folks will stand down.

OK—I haven’t really lost my mind.  But it’s important to remember that one reason supply-side doesn’t work in practice is because it doesn’t work in theory.

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One comment in reply to "Tax Attacks"

  1. Misaki says:

    I keep forgetting that when people discuss changes in tax rates, they focus on the marginal effects and never the long-term effects.

    If you raise taxes on the middle class by 10% of income, this will lead to a decrease in demand/consumption in the short term… but in the long term, prices of houses, iPhones, etc. will just adjust and so it will have minimal effect.

    On the other hand…

    >people will work harder (longer, really)

    In such conversations people assume that this would be a good thing, to have people working longer or harder (doing more work in either case).

    Why? And what does it mean for how to fix unemployment?

    “Higher individual contribution to GDP” is NOT a proxy for “helping to create jobs”.