According to academic economists, the fiscal policy debate over how to stimulate the economy and reduce the budget deficits has been resolved. However, several studies have found that reducing government spending has no significant affect on economic growth.
1/21/2013 @ 3:42PM
The fiscal policy debate over how to stimulate the economy and reduce the budget deficits has been resolved – at least among academic economists. The way forward lies in reducing tax rates – especially on corporations and high-income individuals – and reducing spending. The way backward lies in pursuing President Barack Obama’s call for more taxes and increased government spending.
That is the conclusion of a survey of the academic literature published in peer review journals since 1983 by William McBride of the Tax Foundation.
"While there are a variety of methods and data sources, the results consistently point to significant negative effects of taxes on economic growth even after controlling for various other factors such as government spending, business cycle conditions, and monetary policy. In this review of the literature, I find twenty-six such studies going back to 1983, and all but three of those studies, and every study in the last fifteen years, find a negative effect of taxes on growth. Of those studies that distinguish between types of taxes, corporate income taxes are found to be most harmful, followed by personal income taxes, consumption taxes and property taxes."
In addition, several of the studies found reducing government spending has no significant affect on economic growth.
The studies surveyed include those conducted by the first Chair of President Barack Obama’s Council of Economic Advisors, Christina Romer and her husband, U. C. Berkeley Professor David Romer; Robert Barro and C.J. Redick of Harvard, as well as studies done by economists in such hotbeds of Keynesian, demand side economics as the International Monetary Fund and the Organization of Economic Cooperation and Development (OECD). These studies examine the experience of individual countries, including the U.S. and Canada, multiple countries, and also cross-country analyses in reaching their conclusions.
McBride’s survey also demolishes the credibility of the Congressional Research Service (CRS) study published last December which found:
No conclusive evidence, however, to substantiate a clear relationship between the 65-year reduction in the top statutory tax rates and economic growth. Analysis of such data conducted for this report suggests the reduction in the top tax rates has had little association with saving, investment, or productivity growth. It is reasonable to assume that a tax rate change limited to a small group of taxpayers at the top of the income distribution would have a negligible effect on economic growth. For instance, the tax revenue projected from allowing the top tax rates to rise to their pre- 2001 levels is $49 billion for 2013 or 0.3% of projected 2013 gross domestic product.
The CRS study is often referenced directly and indirectly by those who favor higher tax rates as part of the overall solution to federal deficits. But, McBride explains:
Their study ignores the most basic problems with this sort of statistical analysis, including: the variation in the tax base to which the individual income tax applies; the variation in other taxes, particularly the corporate tax; the short-term versus long-term effects of tax policy; and reverse causality, whereby economic growth affects tax rates. These problems are all well known in the academic literature and have been dealt with in various ways, making the CRS study unpublishable in any peer-reviewed academic journal.
The implications of this new, emerging consensus among economists is clear for the fiscal policy debate.
First, the Obama tax increase on those with high incomes will reduce economic growth and lead to less job creation. Using the estimates provided by the Romers’ research, the Obama tax increase will reduce the real size of the U.S. economy by about 1% over the next 10 quarters. The loss of $160 billion in output will also reduce overall revenues by about $30 billion a year, wiping out about half of the projected revenues from the tax increase. It will also fail as social policy, destroying approximately 200,000 jobs.
Second, the President’s strategy of increased government spending will not stimulate the economy, nor will immediate spending cuts diminish overall economic growth. As a consequence, a pro-growth fiscal policy would favor immediate reductions in federal spending over promised future reductions in government outlays.
Absent a better package of spending cuts, that means the Republicans should allow the immediate, $100 billion a year reduction in government to take effect. The dislocations from the spending cuts would be real, but short lived. The re-allocation of $100 billion in spending from the government to the private sector represents less than 3% of total federal outlays and about 0.6% of Gross Domestic Product, an order of magnitude that can be accommodated easily in a $16 trillion American economy. The IMF’s study of 173 cases of “fiscal consolidation” in 15 advanced countries between 1980 and 2009, for example, found cutting spending by 1% of GDP was slightly negative but not statistically significant. (By contrast the study found a tax increase of the same magnitude would reduce GDP buy 1.3 percentage points after two years.)
In addition, opponents of spending cuts ignore that all spending has to be paid for by taxes now or in the future. Therefore, a $100 billion a year reduction in spending over 10 years is equivalent to a $1 trillion reduction in future taxes. And, lower taxes are associated with higher growth rates.
Third, the corporate tax rate should be cut by at least 10 percentage points to 25%. According to a study by Young Lee and Roger Gordon of Hanyang University, South Korea and University of California, San Diego, that alone would increase economic growth by between one and two percentage points a year for five years to come. Choosing the mid-point and assuming a 2013 effective date, cutting the corporate tax rate to 25% would increase the average growth rate for the next 10 years to 3.6% from the CBO’s baseline forecast of 2.8%.
According to the Congressional Budget Office “rule of thumb,” every 0.1% increase in the average rate of economic growth over the next ten years reduces the budget deficit by $314 billion. Therefore, such a reform of the Corporate tax system would cut the fiscal deficit by $2.5 trillion. More important, higher growth would add millions of jobs to the U.S. economy.
By contrast, the President’s call for more taxes to fund an ever-larger government risks a backward move toward European stagnation and persistent high unemployment. This mix of austerity policies has been tried in Greece, Spain, and Portugal and, as 23 out of 26 academic studies anticipated, has led to economic contraction, soaring unemployment and, as a consequence even greater fiscal imbalances.
Moreover, the combination of these experiences and economic studies indicates President Obama’s favored policy mix fails even the Progressive’s totem of “justice as fairness” as put forward by Harvard philosopher John Rawls. Higher tax rates on high incomes are desirable only if they do not hurt the least advantaged. But, the consequences of continued slow growth and high unemployment fall most heavily on the least skilled and those who lose their job or the opportunity for a better life, to say nothing of the broad middle class that has suffered a historic decline in median income during the past four years.
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