Reprinted from Al Jazeera
Many observers have been amused by the boasting war going on between the candidates for the Republican presidential nomination with their tax cut plans. Former Florida Governor Jeb Bush led the way with a multi-trillion dollar tax cut plan that is supposed to lead to 4 percent annual growth over the next decade.
Not to be outdone, real estate developer Donald Trump came out with an even bigger plan that would get us to 6 percent annual growth, he promised. Most of the other contenders have now produced similar plans, even if their growth targets are not quite as ambitious.
There is nothing wrong with thinking big, but the problem with the Republican tax cut proposals is that they are not serious. The Congressional Budget Office (CBO) projects a baseline growth rate for the decade after the next president takes office of less than 2.2 percent. There is a legitimate story in which, other things equal, lower tax rates can increase incentives. Lower tax rates mean people have more incentive to work and firms have more incentive to invest.
But these effects are relatively small and largely offset by other factors. For example, if higher income people pay less money in taxes in their working years, then they may be able to save more money and retire a year or two earlier than if they had been paying higher taxes. In this case the net effect of a tax cut on people's willingness to work could even be negative.
This is why when CBO and other neutral analysts have tried to project the growth impact of even large tax cuts, they find them to be relatively small. If Bush or Trump promised us 2.4 or 2.5 percent annual growth, this would be optimistic, but at least serious. Four percent annual growth doesn't pass the laugh test and 6.0 percent, well, is Trump sized.
Of course the growth story could easily go the other way. If the tax cuts are matched by cuts in spending on infrastructure, education or other areas of public investment -- cuts that Congressional Republicans have been pushing -- then we could end up with less growth. In fact, recent research suggests that even cuts in programs such as Temporary Assistance for Needy Families and the Supplemental Nutrition Assistance Program may result in lasting economic damage, since the children of families getting these benefits will do worse in school and their subsequent careers if they are cut.
Not only do tax cuts fail as a growth strategy in theory, we actually did test the tax cut route: twice. Even with the Reagan tax cuts, we had marginally slower growth in the 1980s than in high-tax 1970s. And the George W. Bush tax cuts were associated with the worst growth performance since the Great Depression.
In short, producing a tax cut plan may be akin to a fraternity ritual that Republican presidential candidates must go through, but it is not a serious policy for promoting economic growth.
Unfortunately the Republicans are not the only party with silly growth myths. The Democrats have their own growth myth around the magical qualities of balanced budgets.
In this myth, President Bill Clinton made the hard choices back in the 1990s. He cut spending and raised taxes to bring the budget into balance. This led to a surge in growth and the lowest unemployment rate in almost three decades. We also saw wage growth up and down the income ladder. Then George W. Bush pissed it all away with his tax cuts and expensive wars. The deficits came back and the economy went to hell.
It's a moving story and we may hear it frequently if former Secretary of State and first spouse Hillary Clinton gets the Democratic nomination. But, like the story that Republican tax cuts spur growth, it's not true.
The first problem is that Clinton's tax increases and spending cuts actually did not balance the budget. In 1996, after all the tax increases and spending cuts were already passed into law, CBO still projected a deficit of 2.5 percent of GDP (or approximately $450 billion in today's economy) for 2000. The reason that we instead had a surplus of roughly the same amount is that the economy grew much more rapidly than expected.
And the reason the economy grew more rapidly than expected was that we had a stock bubble that drove consumption through the wealth effect. People spent more than they would have otherwise because they thought they had lots of wealth in the stock market. The bubble also drove investment, as anyone with an idea about selling on the Web could raise hundreds of millions on Wall Street.
This was all lots of fun, until the bubble started to deflate in March of 2000. At its trough in the summer of 2002 the S&P had lost almost half its value and the NASDAQ almost 80 percent. When the bubble burst, the economy went into recession and surpluses turned into deficits.