Do Tax Cuts Lead to Economic Growth?

Budget season in Charleston and Washington, D.C. has once again presented the spectacle of competing tax philosophies. Conservatives argue for cutting taxes as a way to unleash economic growth and job creation. They assert that high taxes discourage the most creative class from economic activity that will ultimately raise all boats. Liberals and progressives, on the other hand, believe that tax cuts unfairly benefit the rich and eliminate revenues that are required for programs that secure a just society. They further argue that tax cuts do not stimulate economic growth in the long term and point out that some jurisdictions with the highest tax rates in the country and the world also have the highest rates of growth. Who is right?

There is one aspect of tax cuts that is not debatable – it is simple arithmetic. If a government cuts taxes it lowers revenues. Unless spending is cut by an equal amount, the government creates a budget deficit. Budget deficits at the federal level are funded by government borrowing. But the more the government borrows, the higher its debt service burden will be in the future. This has two major consequences.

First, the more money that must be devoted to paying off debt, the less money is available for direct spending on needed government activity. Second, government borrowing sucks up investment funds from the market that would otherwise be available to businesses for making capital investment – new plant, machinery and technology. New capital investment is required for productivity growth, and productivity growth is required for overall economic growth.

Conservatives dispute that tax cuts lower revenues by resort to a form of economic voodoo called “dynamic scoring.” They argue that because tax cuts will stimulate economic growth, which will lead to a healthier base economy upon which the lower tax rates will apply, it is incorrect to focus only on the immediate drop in tax revenues created by the proposed tax cuts. According to this argument, eventual new tax revenues created by future economic growth should be counted to assess the true impact of the tax cuts.

Very few economists are comfortable relying on dynamic scoring because there are no certainties about the effects of tax cuts on economic growth. Revenue feedback from increased growth fluctuates, when it occurs at all, and never gets above 20% of the original cuts. Nevertheless conservative politicians love dynamic scoring. It is a sales pitch they can use to undercut opposition and it does not require them to provide facts or credible explanations. For example, Treasury Secretary Steve Mnuchin asserted on April 26 that the lower tax rates in President Trump’s tax plan will boost GDP growth from its current 1.7% rate to a new level of 3%, and that surge would completely pay for the plan. But in a poll of 37 economists conducted by the University of Chicago’s Booth School of Business, not one believed that the proposed tax cuts could pay for themselves.

The historic evidence is that tax cuts do not lead to long term economic growth. Recent history provides support for this. Both President George H. W. Bush and President Clinton raised taxes in the 1990s and the economy boomed. Incomes grew at the fastest rate since the 1960s. Then President George W. Bush passed a large tax cut in 2001 and boldly predicted that prosperity would follow. It didn’t. The economy stumbled at a low growth rate until it crashed in 2008. A similar example of this at the state level is provided by the Kansas experience, in which sweeping tax cuts were followed by sluggish growth. Of course, correlation is not necessarily causation – tax increases may not cause booms and tax cuts may not cause busts. Instead we are asking whether tax cuts lead to economic growth and there is just no evidence for this.

From what little we know of the proposed Trump tax plan, wealthier taxpayers will be certain to benefit from lower marginal rates on income and capital gains. The Congressional Research Service, a non-partisan service of the Library of Congress, analyzed the effect of reductions in the top marginal tax rates since 1945. In a September 2012 report the CRS said:

There is not conclusive evidence, however, to substantiate a clear relationship between the 65-year steady reduction in top tax rates and economic growth. Analysis of such data suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth.

The CRS did find, however, that decreasing the top marginal tax rates was associated with increasing the share of national income going to those who were already wealthy.

So on the question of whether tax cuts lead to economic growth the careful answer, based on the evidence, is no. This begs the question what policies do increase economic growth, which will be the subject of a future article.