What is 'pro-growth' tax reform?

Improving the economy isn't as simple as cutting taxes

Jason Reed/Reuters
U.S. President Obama shakes hands with John Boehner as Joe Biden looks on, upon arriving to address a joint session of Congress on Capitol Hill in Washington. The author argues that effects of the tax cuts in the Obama jobs plan must be carefully balanced.

I testified before the House Budget Committee this morning, for a hearing entitled “The Case for Pro-Growth Tax Reform.” My full written testimony is available at the committee’s website and also at the Concord Coalition site, here. (Later you should be able to see the video on the committee website.)

As I explained at the opening of my testimony:

[T]he “case” for pro-growth tax reform is easy and non-controversial—as 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 “pro-growth.”

Growing the economy through tax policy isn’t as simple as “cutting taxes” 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’t necessarily pass society’s cost-benefit test, even based on a narrower and naïve 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 “pro growth” 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’re starting from relatively low rates), how large the responsiveness (“substitution effects”) of households and businesses to those rates (often pretty small), and how other factors (such as “income effects”) may swamp those responses to price changes.

(iii) In an economy still recovering from recession, we have to worry about getting back to “full employment” (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’ 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’s own Treasury Department), and are not the kind of tax cuts that provide high “bang per buck” in a recessionary economy.

That is, growing the economy isn’t as easy as just “cutting taxes,” 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’s never been our experience by the way), national saving–the sum of public plus private saving–will 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’s not enough that tax cuts are “good” (especially for those who receive them). They have to be good enough.

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