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<!-- you can have any number of categories here --> [[Category:William Gale]] [[Category:Aaron Krupkin]] [[Category:Kim Rueben]] [[Category:Supply-Side Economics]] <!-- 1 URL must be followed by >= 0 Other URL and Old URL and 1 End URL.--> {{URL | url = http://assets1c.milkeninstitute.org/assets/Publication/MIReview/PDF/05-12-MR68.pdf}} <!-- {{Other URL | url = }} --> <!-- {{Old URL | url = }} --> {{End URL}} {{DES | des = Many conservatives apparently believe that federal tax cuts have borne rich fruit for the country, or, at worst, that the jury is still out. But this seems to be a case of “who are you going to believe – us, or your lying eyes?” At the federal level, there is virtually no evidence that broad-based tax cuts have had a positive effect on growth. | show=}} <!-- insert wiki page text here --> <!-- DPL has problems with categories that have a single quote in them. Use these explicit workarounds. --> <!-- otherwise, we would use {{Links}} and {{Quotes}} --> {{List|title=There is No Reason to Believe that Tax Cuts are an Elixir for Economic Growth|links=true}} {{Quotations|title=There is No Reason to Believe that Tax Cuts are an Elixir for Economic Growth|quotes=true}} {{Text | Many folks, and from time to time, majorities in Congress, apparently believe that the cure for what ails the economy is lower taxes – in particular, lower tax rates for high-income earners. Now this enthusiasm has spread to state governments that are led by conservatives, offering new tests of a proposition that has generated scant evidence of success elsewhere. Failure of this idea at the federal level does not necessarily imply that tax cuts would fail to increase output and jobs at the state level. For one thing, lower taxes in one state might lure existing businesses (and jobs) from other states, even if they yield no overall increase in employment or output. But it’s also worth noting that the stakes are higher for the states. Washington can nance shortfalls in revenue by selling bonds to the public or by borrow- ing from the Federal Reserve – in effect, printing money. States are far more con- strained by the skepticism of the private credit markets or constitutional prohibitions against de cit nance, or both. Thus, any failure of supply-side economics to work its William Gale holds the arjay and Frances miller Chair in federal economic policy at the Brookings institution (wgale@brookings.edu). aaron KrupKin is a research assistant at Brookings (akrupkin@brookings.edu). Kim rueBen is a senior fellow at the urban institute (krueben@urban.org). all three are af liated with the urban-Brookings Tax policy Center. The authors thank the laura and John arnold Founda- tion and the ewing marion Kauffman Foundation for nancing the original research cited in this article. The ndings are the responsibility of the authors and do not necessarily re ect positions of the Tax policy Center, the Brookings institution or the urban institute. magic could force punishing cuts in state programs. present at the creation First, a little history. Ever since the 1970s, when Jude Wanniski (then a Wall Street Jour- nal opinion editor) and Arthur Laffer (then a young college professor) came up with the ideas that are now referred to as supply-side economics, conservative politicians have been unable to resist the siren song of tax cuts for big earners. The claim, of course, is not that high-end tax breaks merely serve the interests of groups that support conservative politi- cians; rather, it is that the tax cuts would serve the broader public interest by increasing in- centives to work and to create (or expand) businesses. In the extreme versions of supply-side eco- nomics that thrived through the early Reagan administration years, supply-siders argued that tax rates were so high that cuts would in- crease the economic growth rate suf ciently to pay for themselves. After decades in which lower tax rates generated less revenue rather than more, today’s supply-siders are more in- clined to make less immodest claims; many Fourth Quarter 2015 5 6 The Milken Institute Review trends advocates argue that tax cuts will spur growth that will make up for part of the revenue losses as they create jobs and private income, asserting that the loss of some tax revenue is worth it due to the boost in economic activity. However, some proponents still can’t help themselves and lapse into the more hyper- bolic claims. inside the beltway Many conservatives apparently believe that federal tax cuts have borne rich fruit for the country, or, at worst, that the jury is still out. But this seems to be a case of “who are you going to believe – us, or your lying eyes?” At the federal level, there is virtually no evidence that broad-based tax cuts have had a positive effect on growth. The vaunted Reagan tax cuts in the early 1980s produced a period of average growth, when growth is (appropriately) measured from peak to peak of the business cycle. In- deed, research by Martin Feldstein, President Reagan’s former chief economist, and Doug- las Elmendorf, the former Congressional Budget Of ce director, concluded that the 1981 tax cuts had virtually no net impact on growth. Indeed, they found that the recovery in the 1980s could be ascribed wholly to monetary policy. It’s also worth noting that they found no evidence that the big 1981 tax cuts induced people to work more. Apparently, no one claims that the 2001 and 2003 Bush tax cuts stimulated growth. The two enabling acts did have the word “growth” in their titles (the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs and Growth Tax Relief Reconcil- iation Act of 2003) and slashed tax rates on ordinary income, capital gains, dividends and estates. Yet growth remained sluggish be- tween 2001 and the beginning of the Great tk Fourth Quarter 2015 7 tk trends Recession in late 2007. Again, the gains that did occur are generally attributed to the Fed’s easy-money policy. But the Reagan and Bush tax cuts, each about 2 percent of GDP, were small potatoes compared to the tax increases during and after World War II, when federal taxes rose by more than 10 percent of GDP. That’s right, not 10 percent of taxes, but one-tenth of the entire economy. Income tax rates went up for virtu- ally everyone, and revenues and rates stayed higher for decades. In fact, between 1944 and 1963, the top tax bracket never fell below 90 percent. According to supply-side theory, that should have killed the economy. Instead, ac- cording to Nancy Stokey (of the University of Chicago) and Sergio Rebelo (of the Kellogg School), real per capita growth rates differed little from the historical averages. Tax rates as determinants of long-term growth fare no better in cross-country com- parisons. Research by Thomas Piketty (Paris School of Economics), Emmanuel Saez (Uni- versity of California, Berkeley) and Stefanie Stantcheva (MIT) found no relationship be- tween how a country changed its top marginal tax rate and how rapidly it grew between 1960 and 2010. The United States, which cut its top rate by over 40 percentage points during that period, grew just over 2 percent annually per capita. Germany and Denmark, which barely changed their top rates at all, experienced about the same growth rate. The story is much the same when total tax burdens are compared. Over the 1970-2012 period, taxes as a share of GDP were 7 percent- age points higher in the rest of the OECD countries (32 percent) than in the United States (25 percent). Yet, per capita annual growth was virtually identical in the rest of the OECD (1.8 percent) as in the United States. So, there is no reason to believe that tax cuts are an elixir for economic growth. When policymakers count on increased business ac- tivity and job creation, as well as revenue to partially offset the initial cost, they are risking serious economic dislocation. There’s an- other problem here, as well. As Piketty and company note, with or without the elusive supply-side effect, high-end tax cuts have ex- acerbated income inequality. Despite all of this, tax breaks for high earn- ers are prominently featured in contempo- rary debate over tax policy. Mitt Romney’s 2012 campaign proposals included tax cuts for the “job creators.” And don’t expect Re- publican candidates to change their tune for 2016. Marco Rubio (along with Utah’s Sen. Mike Lee) has come up with the Economic Growth and Family Fairness Tax Reform Plan; Rand Paul has checked in with his Fair and Flat Tax. While the plans are quite differ- ent, both cut taxes at the high end of the in- come ladder. hard numbers The zeal for lowering income tax rates, espe- cially at the top, spread beyond Washington decades ago. In the 1990s, six states cut taxes by more than 10 percent, mostly by enacting signi cant personal income tax cuts. Their subsequent growth records are mixed. Gross State Product (GSP) did grow faster, on aver- age, in the six tax-cut states combined than in the rest of the country. But that was mostly explained by the explosive growth of the - nancial sector, which is centered in Connecti- cut, New Jersey and New York, and was surely more a product of the Clinton-era boom in nancial engineering and the dot-com bub- ble than of state tax policy. On average, the other tax-cut states (Massachusetts, Delaware and Colorado) grew more slowly than the rest of the country. Moreover, employment grew 8 The Milken Institute Review previous page: jim tsinganos at a faster rate in the rest of the country than in the six tax-cut states. New Jersey’s tax cut was anchored on a 30 percent reduction in personal income taxes from 1994 to 1996. Using county-level data on employment, Robert Reed (University of Canterbury) and Cynthia Rogers (University of Oklahoma) found that New Jersey experi- enced strong employment growth after the tax cut – but so did counties with similar eco- nomic pro les in nearby states that did not have tax cuts. The net effect of the tax cut, measured by the difference in employment Some states, notably California, Maryland and New York, have retained increases in top marginal income tax rates that were intro- duced in recent years to address revenue shortfalls. But the supply-side spirit lives on in a number of others, which have cut per- sonal income taxes and corporate income taxes, and provided special breaks for busi- nesses, with the goal of spurring growth. The most widely reported recent state in- come tax cut occurred in Kansas in 2012. In the 30 years prior, Kansas’ economic growth rate had lagged consistently below There is no reason to believe that tax cuts are an elixir for economic growth. When policymakers count on increased business activity and job creation, as well as revenue to partially offset the initial cost, they are risking serious economic dislocation. gains between New Jersey and the nearby economic regions, was small and statistically insigni cant. Between 2001 and 2007, Arizona, Louisi- ana, New Mexico, Ohio, Oklahoma and Rhode Island cut personal income taxes. However, there was no discernable impact on economic activity. From 2001 to 2012, these states grew, on average, at virtually the same rate as the rest of the U.S. economy. In fact, extending the measurement period through 2014, four of the six states experienced de- clines in their shares of total U.S. employ- ment. Two states, New Mexico and Oklahoma, did experience net gains in employment share over the extended period. But a far more plausible explanation centers on the boom in oil and gas fracking, which was hardly related to state income tax policy. the averages for neighboring states and the nation as a whole. Hence Gov. Sam Brown- back pressed for a tax cut that would be “like a shot of adrenaline into the heart of the Kan- sas economy.” Initially, Brownback submitted a revenue- neutral plan that reduced income tax rates across the board and effectively exempted small-business income from all tax. To offset the cost, he proposed to eliminate itemized deductions, make a temporary sales tax in- crease permanent and cap state spending. But the Legislature passed a bill with quite differ- ent provisions. Starting in 2013, the top rate of 6.45 percent was eliminated, the next bracket (income above $15,000) was cut from 6.25 percent to 4.8 percent, and the lowest rate was cut from 3.5 percent to 2.7 percent. Taxes on pass-through income from small Fourth Quarter 2015 9 trends businesses were eliminated, reducing the ef- fective state income tax rate on those busi- nesses to zero. Brownback adopted the plan as his own, calling the legislation a “real live experiment” in supply-side economics. The tax cuts did not produce the hoped- for growth, though, and more revenue was lost than originally anticipated. Fiscal year Once progressive income taxes are cut, the political path of least resistance for reversing the revenue losses is to raise indirect taxes that are usually regressive. 2014 revenues were $700 million lower than the previous year – $330 million less than ex- pected – in a period in which most of the American economy was picking up steam. Put in context, these numbers are pretty signi - cant: $330 million represents more than 5 percent of Kansas’ government spending from general funds. Responding to the gloomy news, both Moody’s and Standard & Poor’s reduced Kansas’ credit rating. Arguably as important, Kansas failed to keep up with the region’s pace of job growth. Kansas’ cumulative job growth rate from Janu- ary 2011 through March 2014 was 3.4 percent – 39 months in which the United States regis- tered 5.5 percent job growth and employment in neighboring Colorado, Oklahoma and Ne- braska grew by 8.2 percent, 5.6 percent and 4 percent, respectively. Even if we focus on the latter half of that period, beginning in January 2013, which was after the tax cut was enacted, Kansas still falls behind. The state’s job growth clocked in at 1.4 percent, compared to the U.S. average of 2 percent. Thus, it seems as if the “live experiment” failed to produce the pro- jected economic gains. Under the threat of large spending cuts, especially for schools, the Kansas Legislature raised taxes in June. However, instead of re- versing the income tax changes and the provi- sion that eliminated tax liability for many businesses, Kansas increased its regressive sales tax to 6.5 percent (from 6.15 percent) and increased the regressive excise tax on cig- arettes by 50 cents a pack. This suggests yet another way in which the experiment failed: once progressive income taxes are cut, the po- litical path of least resistance for reversing the revenue losses is to raise indirect taxes that are usually regressive. Over the past few years, other states have also tried cutting income taxes, partially off- setting the revenue losses by raising their sales taxes. Since 2011, Gov. Scott Walker of Wisconsin (who was, as of mid-summer, one of the leading candidates for the Republican presidential nomination) has signed a collec- tion of tax cuts that reduced revenue by roughly $2 billion – a remarkable loss for a state with general-fund spending of about $15 billion. However, the expected job growth and budget surpluses in Wisconsin did not arrive. Gov. Walker recently signed a budget that cut spending on higher education, roads and scienti c research. In Louisiana, many politicians thought that the economic boom and revenue gains after Hurricane Katrina would stand the test of time. The state took the opportunity to cut income taxes to the tune of $700 million, add- ing to the woes of a budget that is vulnerable to the business cycle and heavily dependent on royalties from oil production. The $1 bil- lion budget surplus in 2007-08 has morphed into a projected de cit of $1.6 billion for the 10 The Milken Institute Review current scal year. In response, Gov. Bobby Jindal froze public-employee wages, scaled back tax expenditures, increased the cigarette tax by 50 cents per pack and raised motor ve- hicle fees. In April 2014, Oklahoma’s governor, Mary Fallin, chose a slightly different approach. She signed a bill that would reduce the state’s top marginal personal income tax rate to 5 per- cent from 5.25 percent by 2016, but only if Fourth Quarter 2015 11 jim tsinganos trends state revenue projections were larger than ex- pected. Because this trigger was based on pro- jections, it was met in December 2014 and, despite a budget shortfall, the tax cut auto- matically went into effect. A second cut, to 4.85 percent, will go into effect after 2016, again provided revenue projections exceed targets. However, with oil and natural gas prices in decline, it is unclear whether the sec- ond round will occur. inconvenient truths While it is too soon to understand the full ef- fects of the recent state income tax cuts, the ex- amples above hardly strengthen the case for supply-side tax cuts. Moreover, these ambigu- ous state experiences tend to reinforce the con- clusions from a voluminous academic litera- ture. Recent studies have generated almost every conceivable nding: tax cuts raise, re- duce or have no clear effect on growth. In ad- dition, the effects of changing different taxes – income, corporate, property and sales – vary dramatically within and across studies. A variety of methodological factors com- plicate interpretation of these ndings: the econometric studies used different dependent variables, analyzed different time periods, employed alternative measures of tax reve- nues or rates or both, included different mea- sures of government spending, controlled for different independent variables and used dif- ferent control groups and identi cation methods. Additionally, balanced-budget re- quirements imply that revenues and spend- ing should be closely correlated, making it es- pecially dif cult to study the independent in uence of taxes or spending. In our own recent research, we worked to be fair to both sides, making fresh estimates of how state tax policy affects economic growth and entrepreneurial activity. We used a frame- work that in prior research had led investiga- tors to the conclusion that lower taxes do stim- ulate growth, extending the sample period and performing a variety of tests to see how sensi- tive the results were to plausible changes in the statistical models. We found that neither tax revenues nor top marginal income tax rates bear any stable relation to economic growth rates across states and over time. Consistent with these ndings, we also concluded that neither marginal tax rates nor tax revenues consistently affect employment. And while the rate of rm formation is nega- tively affected by top income tax rates, these effects are small. The gist: there is no guaran- tee – and there should not even be a pre- sumption – that cutting state income taxes will boost economic growth. whack-a-mole economics At the core of supply-side economics is Ar- thur Laffer’s back-of-the napkin curve illus- trating the undeniable reality that, at some point, higher tax rates will lead to lower rev- enues as well as fewer jobs and slower growth. But this does not imply there are many real- world examples of tax rates so high that cut- ting them would have much impact on jobs or growth. That has been amply demon- strated at the national level, where tax cuts have eroded revenue without discernable ef- fect on economic activity. The states have no good reasons to believe that tax cuts will bring the desired manna. Yet some continue to erode their tax bases in the name of business growth in an era in which few states can afford to cut critical services (that businesses care about) ranging from education to infrastructure repair. Some ideas live on and on, no matter how much evidence accumulates against them. States that accept them as gospel anyway do so at their peril. }}
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