What is 'pro-growth' tax reform?
I this morning, for a hearing entitled 鈥淭he Case for Pro-Growth Tax Reform.鈥� My full written testimony is available at the committee鈥檚 website and also . (Later you should be able to see the video on the committee website.)
As I explained at the opening of my testimony:
[T]he 鈥渃ase鈥� for pro-growth tax reform is easy and non-controversial鈥攁s achieving a stronger economy makes pursuing any other social goals easier (deficit reduction, higher and fairer standards of living, greater investment in higher quality public goods and services, etc).
The disagreement is over what makes a given tax reform 鈥減ro-growth.鈥�
Growing the economy through tax policy isn鈥檛 as simple as 鈥渃utting taxes鈥� to reduce overall tax burdens. Tax cuts all have benefits, but the first thing one learns in an economics class is in a world of scarce resources, we maximize well being by weighing costs against benefits, and at the margin starting from where we are right now. Tax cuts that might benefit particular households and businesses don鈥檛 necessarily pass society鈥檚 cost-benefit test, even based on a narrower and na茂ve goal of maximizing GDP because:
(i) If deficit financed, the direct reduction in public saving will typically outweigh any positive response from private saving, so national saving and economic growth falls. This is the biggest factor preventing simple cuts in overall tax rates from being 鈥減ro growth鈥� over the longer term.
(ii) How taxes are cut matters: marginal tax rates are what matters for supply-side growth effects (increases in incentives to work and save), and those responses depend on how large the change in marginal rates (we鈥檙e starting from relatively low rates), how large the responsiveness (鈥渟ubstitution effects鈥�) of households and businesses to those rates (often pretty small), and how other factors (such as 鈥渋ncome effects鈥�) may swamp those responses to price changes.
(iii) In an economy still recovering from recession, we have to worry about getting back to 鈥渇ull employment鈥� (where we are putting all of our productive capacity to use) before turning to growing the productive capacity of the economy over the longer term. Tax policies that help increase demand for goods and services (and hence businesses鈥� demand for workers) can be quite different from those that increase the supply of labor and capital.
Our experience with the Bush tax cuts has demonstrated each of these challenges, as their major contribution to record-high deficits clearly reduced national saving and economic growth, were not very effective at growing the supply side of the economy (even according to the Bush Administration鈥檚 own Treasury Department), and are not the kind of tax cuts that provide high 鈥渂ang per buck鈥� in a recessionary economy.
That is, growing the economy isn鈥檛 as easy as just 鈥渃utting taxes,鈥� because the loss of revenues feeds dollar-for-dollar into a higher deficit and reduced public saving. Unless private saving responds immediately or even eventually like gangbusters to the form of the tax cut (and that鈥檚 never been our experience by the way), national saving鈥搕he sum of public plus private saving鈥搘ill likely fall. So the first effect of a tax cut on economic growth is that direct and certain negative effect of the deficit on saving, that we gamble away for the hope of an uncertain positive private sector response to at least partially offset it. But empirically, it never comes close to fully offsetting it, so empirically, there is always a cost to tax cuts that has to be weighed against any benefits.
It鈥檚 not enough that tax cuts are 鈥済ood鈥� (especially for those who receive them). They have to be good enough.
