Critics of the Bush tax cuts often dismiss the tax changes as a failed experiment in free-market economics. Noting that economic growth was slower in the years following the cuts than in the years preceding them, some critics see the experience as evidence that tax cuts simply do not work.
But the claim that these tax cuts exemplified free-market economic thinking is baseless. The Bush tax cuts had a number of problems from a market-oriented perspective: they were phased in slowly, set to expire within a decade, entailed a Keynesian emphasis on stimulating aggregate demand, and—above all—were undertaken without any effort to reduce spending.
In light of these problems, there is no reason to overturn decades of theoretical and empirical research supporting the link between low taxation and growth. The episode offers a cautionary lesson in how not to cut taxes.
The “Bush tax cuts” are the product of two staggered tax reforms: the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. The 2001 tax cut immediately reduced marginal income tax rates, but by a small amount. Each of the top four rates was reduced by 0.5 percentage points in the first year. In 2002, a new bottom marginal rate reduced the tax applied to the first several thousand dollars of income from 15 percent to 10 percent.
As originally designated in the 2001 law, all tax changes were scheduled to take effect by 2006. The top marginal income tax rate was to have fallen from 39.6 percent to 35 percent, while the bottom rate was to have fallen from 15 percent to 10 percent.
The 2003 tax cut accelerated this process and immediately implemented income tax rate reductions that had not been scheduled to take effect for one to three more years. In addition, the 2003 law immediately cut the top marginal capital gains tax rate for assets held more than a year from 20 percent to 15 percent and the bottom long-term capital gains rates from 8 and 10 percent to 5 percent (and eventually to 0 by 2008).
In addition to reducing marginal tax rates, each tax cut also included a number of additional provisions. The 2001 tax cut, for example, included a one-time retroactive “tax rebate.” The Treasury sent checks (up to $300 for singles and $600 for married couples) to taxpayers who had filed their taxes in 2000. It also increased the standard deduction for joint filers, expanded the per-child tax credit, increased the tax credit for qualifying child-care expenses, introduced a new deduction for qualified property owners, and created or expanded various education credits and deductions. The 2003 cut accelerated the implementation of these provisions as well.
Despite the shortcomings of these tax cuts, there is strong theoretical and empirical support for low taxation. Keynesian models, for example, emphasize the short-run benefits of tax cuts, stressing that they put money in the pockets of consumers and in the accounts of businesses. According to the Keynesian view, this increases purchasing power and boosts aggregate demand. The “real business cycle” school of thought, on the other hand, focuses on the longer run and emphasizes that low marginal tax rates tend to increase peoples’ incentives to work and save, increasing aggregate output.
Finally, growth models teach us that lower and more uniform rates can improve long-run economic growth because high tax rates can be an impediment to investment in research and development, and because tax policies that favor one sector over another can drive labor and capital (including human capital) into less-taxed but lower-productivity sectors.
Good tax systems are stable and predictable. From the beginning, however, the Bush tax cuts made policy less predictable because the tax changes were set to expire at the end of 2010. This automatic expiration date was an unfortunate consequence of the fact that these tax changes were passed under a legislative procedure known as reconciliation. Since it was unclear that his allies in the Senate could procure the 60 votes necessary to enact the 2001 tax cut, President Bush decided to use reconciliation because it permits budget legislation to pass the Senate with a simple majority of senators.
However, there was a catch. The Byrd Rule, adopted in 1985, prohibits the use of reconciliation to pass legislation that increases the deficit beyond a 10-year term. Because the 2001 and 2003 tax acts made no serious effort to cut spending, the cuts were projected to add hundreds of billions of dollars to the deficit. Thus they had to expire at the end of 2010. The Tax Act of 2010 gave the rates another two years of life, but their looming expiration at the end of 2012 now constitutes one part of a “fiscal cliff” that threatens to tighten fiscal policy in the first part of 2013.
Tax cuts with expiration dates have two deleterious longer-run effects.
First, expiration dates diminish the potency of tax cuts by discouraging some investments at the margin that would have taken place if lower tax rates had been promised for a longer period of time. For example, longer-term investments—in new employees, new equipment, or new facilities—would have looked more attractive if rates hadn’t been scheduled to increase in a few years.
Second, sunset provisions may increase policy uncertainty. In the 1990s, there were fewer than a dozen temporary provisions in the tax code. Now, there are more than 140. Economists have long argued that policy uncertainty undermines economic growth.
While the 2001 and 2003 tax cuts did reduce marginal rates, tax policy throughout the 2000s also reflected a preoccupation with exemptions, deductions, rebates, and credits. The 2001 tax bill, for example, included rebates and increased the per-child tax credit from $500 to $1,000. Research by Matthew Shapiro and Joel Slemrod suggests that these Keynesian aspects of the cuts were of little economic benefit. They found that fewer than 25 percent of households increased consumer spending because of the rebate. Most survey respondents used the tax rebate to pay off debt rather than spend more.
The most significant problem with the Bush tax cuts was that they were not matched with spending cuts. In fact, Washington went on a historic spending binge: From 2001 to 2009, federal spending leapt from 18.2 to 25.2 percent of GDP. This was the largest such increase in any eight-year period since World War II.
In contrast, eight years after the so-called Kennedy tax cuts, spending as a share of GDP had increased just 1.1 percentage points, and eight years after the Reagan tax cuts, spending as a share of GDP had actually fallen 1.1 percentage points.
A tax cut without a spending cut can raise two problems, one involving economic incentives, the other political incentives.
A tax cut without a spending cut is not a tax cut; it is a tax deferral. To the extent that people are forward-looking and can see that deficits require future tax hikes, they will forgo current consumption in order to save for the inevitable tax increase. In this case, government borrowing will crowd out, or displace, private consumption and investment, reducing the effectiveness of the tax cut.
The idea that humans are perfectly forward-looking may strike some as implausible. And indeed, there is a great deal of economic debate about this theory.
Unfortunately, to the extent that people are not forward-looking, a tax cut without a spending cut raises a completely different problem, this one involving political incentives. In this scenario, shortsighted voters can be deluded into thinking government spending is less expensive than it really is. This idea, originally developed by Italian economist Amilcare Puviani, is known as “fiscal illusion” and has become a central part of the research program of Nobel laureate James Buchanan. Buchanan argues that the opaque nature of deferred taxation causes people to improperly discount the cost of government services and therefore to demand more of them than they normally would.
This phenomenon causes bad policy to beget more bad policy; poorly considered tax reform entices voters to demand more government services, which will need to be paid for with much higher taxes in the future.
Buchanan’s emphasis on fiscal illusion challenges an argument for tax cuts that is often associated with another free-market Nobel laureate, Milton Friedman. This is the idea that a tax cut deprives government of resources, which “starves the beast,” and eventually reins in spending.
Among policy pundits, Friedman’s view is much better known than Buchanan’s view. Nevertheless, the data seem to support Buchanan’s view. At the federal level, where the government is allowed to finance operations by borrowing, tax cuts seem to have done nothing to restrain the government’s ability to spend.
Partial Bill, Bigger Government
Moreover, empirical research analyzing U.S. quarterly data from 1959 to 2007 by West Virginia economist Andrew T. Young suggests the fiscal illusion effect is real: when voters are not presented with the bill for big government, they demand bigger government. David and Christina Romer recently corroborated Young’s finding using a different data set and different techniques.
Even if we ignore the Great Recession, economic growth averaged just 2.5 percent in the 26 quarters following passage of the 2001 tax cut. To put this in perspective, economic growth had averaged 3.7 percent in the 26 quarters preceding the cut.
Proponents might well respond that growth would have been worse in the absence of the tax cuts, and the truth is that we will never know what would have happened had they not passed. To complicate matters, many other policies—from trade to regulation to monetary policy—became decidedly less market oriented in the first decade of the 21st century, and it is not easy to disentangle the effects of these policies from each other.
What we do know, however, is that the tax cuts themselves were theoretically flawed. They were phased in slowly, expired quickly, focused inordinately on boosting aggregate demand, and—most significantly—synchronized with massive spending increases, all of which made them less effective.
This episode also reveals that the government cannot be contained by tax cuts alone. As long as policymakers have the option of financing their programs with deficit spending, taxpayers will underestimate the true cost of government programs and the “beast” will continue to grow while adding to future tax burdens.
Matthew Mitchell ([email protected]) is a senior research fellow at the Mercatus Center at George Mason University and the lead scholar on the Project for the Study of American Capitalism. Andrea Castillo ([email protected]) is a program associate for the Spending and Budget Initiative at the Mercatus Center at George Mason University. They are the authors of What Went Wrong With the Bush Tax Cuts, from which this article was excerpted. Used with permission.
Matthew Mitchell and Andrea Castillo, “What Went Wrong With the Bush Tax Cuts,” the Mercatus Center:http://heartland.org/policy-documents/what-went-wrong-bush-tax-cuts