Tax testimony at the JEC: Debunking supply-side mythology.

April 21st, 2016 at 10:43 am

Testified yesterday before the Joint Economic Committee–here’s my full write up.

Here are my main findings:

  • Fairness, simplicity, and revenue raising are often complementary: by closing regressive loopholes in the tax code, we reduce incentives to game the system, eliminate wasteful tax breaks that exacerbate inequality without promoting growth, and raise more revenues.
  • Based on demographics, inflation, debt service, and rising health costs (though measures in the Affordable Care Act have helped to slow that growth rate), a sustainable fiscal policy will likely require more, not less, revenues going forward.
  • I find no evidence to support the claim that supply-side tax cuts come anywhere close to paying for themselves or are even particularly pro-growth.

Let’s focus here on that last part: that supply-side tax cuts are not pro-growth. The testimony takes two angles on this point. First, citing an important paper by Bill Gale and Andrew Samwick, I point out various ways in which team trickle-down gets the theory wrong.

That is, the Republican witnesses yesterday, notably Art Laffer, assert with religious fervor, that of course cutting taxes boosts growth, based on that old chestnut that if you tax something–labor and capital in the supply-side case–you’ll get less of it. But Gale/Samwick point out that that may or may not be true, based on behavioral reactions to the cuts (“income” vs. “substitution” effects), how the tax cuts are financed, and changes in effective rates. And even if conditions are such that cuts do boost supply-side variables, there’s the question of magnitude. The supply-siders assume economically large responses.

In other words, the theory is ambiguous, which means one must look at the evidence.

With help from Ben Spielberg and Rob Cady, I made many scatterplots, featured here (see data note from the testimony below). Simple stuff, just looking under every rock we could think of to try to find the predicted negative correlation between top tax rates and jobs, GDP, productivity, investment, income, and revenues, from the 1940s to now. As the note below says, we tried levels, changes, lags…and found nothing–not one case–that supported the theory.

The testimony is very clear as per the limits of such simple analysis. The relationship between growth and taxes is far more complex than what’s captured in these figures, of course. But the absence of any correlation over time should make policymakers extremely skeptical of supply-side growth claims (as I note in the testimony, there’s evidence that temporary tax cuts are likely to be growth-inducing during recessions, but that’s through demand-side impacts).

Such consistent lack of correlation should put the burden of proof on the supply-siders to convince the rest of us of the growth effects–using empirical evidence, not model-based estimates, as another witness, Scott Hodge of the Tax Foundation did–of their proposals.

One last point. The testimony also points out that recent state experiments in supply-side growth effects, such as in Kansas, are turning out just as badly as the national scatterplots would predict.

Evidence at the sub-national level — where various states, led by Kansas, have been aggressively cutting taxes while policy officials tout the benefits of supply-side tax cuts — also tilts strongly against tax cuts as a growth strategy.  The cuts in Kansas that took effect in 2013, for example, have now blown a $400 million hole in the state’s budget.  When one of my fellow witnesses, Art Laffer, helped design these cuts, he predicted(along with Stephen Moore of the Heritage Foundation) that they would provide an “immediate and lasting boost” to the Kansas economy.  Yet not only have the cuts caused serious underfunding of the state’s education system, they’ve also coincided with weak job and GDP growth.  The Kansas Legislative Research Department’s projections suggest that the economy will remain weaker than the overall US economy for the foreseeable future.

Menzie Chinn happen to put up some useful analysis of this point yesterday, showing disappointing jobs and growth outcomes in states that have undertaken these sorts of experiments relative to those that have not.

Based on the willingness of some governors and their legislatures to anoint themselves in supply-side snake oil, I consider this a very important area of research going forward. As I’ve said in recent days, I know: if facts could kill the supply-side growth myth, it’d be long dead. But facts are all we’ve got and we must hammer away with them.

Data Note re Scatterplots

Each data point in each chart represents a calendar year.  The top federal marginal income tax rate (from the Tax Policy Center) is on the X-axis of each chart; the Y-axes represent the growth, from one year prior, of the variables in question.  Productivity is for the nonfarm business sector; real capital services come from economist John Fernald’s growth accounting dataset; GDP has been adjusted for both inflation and population size; and the 2013 value for real median family income (Census Bureau) has been imputed because of changing survey methods.

While these charts only show the non-relationship between top marginal tax rates and contemporaneous economic activity, looking two, three, or four years out does not change the findings.  In fact, longer lags often lead to an increased positive correlation with higher top marginal tax rates, a result that stands in direct contrast to what tax cut proponents typically predict.

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One comment in reply to "Tax testimony at the JEC: Debunking supply-side mythology."

  1. Bruce Webb says:

    “notably Art Laffer, assert with religious fervor, that of course cutting taxes boosts growth, based on that old chestnut that if you tax something–labor and capital in the supply-side case–you’ll get less of it.”

    Yes but you have to examine the buried assumption. What is being taxed when you increase marginal rates on capital? Is it “investment” and so “cumulative gains”? Or instead “realized gains”? That is is Homo Oeconomicus driven by “accumulation” or “consumption”. The Laffer School implicitly asserts that capitalists are driven by accumulation and that any tax on capital by reducing rate of return with discourage investment. Instead if you believe (as is supported by all history since forever) that the rich are driven by consumption and display then taxes on realized gains penalizes consumption and reward reinvestment and so future consumption.

    This is not so much a test of economics but instead psychology as tested by historical practice. What actually marked the Reagan cuts in marginal rates ultimately followed by the Bush II cuts? Under Laffer’s theory reinvestment should have gone up and consumption if anything gone down (as a wasted opportunity for accumulation). Instead the wealthy in the 80s and even more so in the 00’s doubled down on consumption in the form of (among other things) multiple houses and mega-yachts.

    We have to remember that under the American tax system there is no penalty for reinvestment, instead tax hits on realized gains. And in the days of top rates of 94% it cost you BIG to cash out enough to buy a 100′ yacht. Now that tax on realized gains might be taxed as low as 20% why NOT buy a 300′ yacht. And to test this all you have to do is visit any port frequented by the top 0.01%. See any big boats?