Should We Pay for Tax Cuts?

The blogosphere exploded last week (see here and here) when a number of Republicans suggested that Congress need not offset the costs of tax cuts. According to Senator Jon Kyl (R-AZ), "you do need to offset the cost of increased spending, and that's what Republicans object to. But you should never have to offset cost of a deliberate decision to reduce tax rates on Americans."

Senate Majority Leader Mitch McConnell actually went further than this, arguing that tax cuts don't need to be offset because they pay for themselves. According to McConnell "there's no evidence whatsoever that the Bush tax cuts actually diminished revenue. They increased revenue, because of the vibrancy of these tax cuts in the economy."

On Senator Kyl's point, we just don't buy it. Why should Congress have to fully offset the costs of extending unemployment benefits or expanding health coverage, but not have to offset equally costly tax reductions? If Congress makes a deliberate decision to the size of government, that's fine; but they should proceed by cutting spending and then taxes commensurately. Or turned the other way, feel free to cut taxes and offset the revenue losses with spending cuts rather than other tax increases, but just kicking the can down the road by adding to the debt is not an economic strategy that markets are going to tolerate much longer.

We also can't help but point out that if only spending increases needed to be offset, policy makers would just replace spending policies with equivalent tax policies. Instead of unemployment insurance, we could have an unemployment tax credit, for example.

There is a reason PAYGO applies to both sides of the budget -- both tax cuts and spending increases cause our deficits and debt to rise.

Which brings us to our next point on Senator McConnell's claim. At current levels, it is exceedingly unlikely that tax cuts would come anywhere near to paying for themselves. Yes, tax cuts generally have a positive effect on growth, especially if we're reducing marginal rates on capital and labor while reducing spending (or tax expenditures) at the same time. But we are nowhere near the "wrong side of the Laffer curve" on income tax rates-- the place where the tax is so damaging that cutting it would raise more revenue than keeping it.

For a little background, the Laffer curve starts from a basic economic premise: if the income tax rate is 100% it will generate little or no revenue, since few would be willing to work for no pay. From there, a reduction in taxes is likely to strengthen revenue collection. But at the other end, the Laffer curve also shows that a tax rate of 0% would raise no revenue. The question from there becomes -- what is the revenue maximizing rate of taxation.

And of course, nobody knows for sure. But you would be hard pressed to find an economist who suggested we were at or past this point. Instead, most economists believe that a tax cut would have a moderate amount of positive feedback.

A number of conservative economists have affirmed this point. Andrew Samwick, former chief economist of Bush's Council on Economic Advisors, has said that while "the ultimate reduction in tax revenues can be less than this first order effect.. [but] No thoughtful person believes that this possible offset more than compensated for the first effect for these tax cuts." Henry Paulson, President Bush's Secretary of Treasury, has said that "As a general rule, I do not believe that tax cuts pay for themselves." And even the 2003 Economic Report of the President stated that "Although the economy grows in response to tax reductions (because of higher consumption in the short run and improved incentives in the long run), it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity.”

So how much revenue feedback do tax cuts generation? Greg Mankiw estimates 15% to 33%. The Heritage Foundation estimated about 30%. And these are conservatives.

According to the CBO, the feedback could range from 28 percent in one extreme, to slightly negative on the other.

The point here is that tax cuts can be good for the economy, and can result in less revenue loss than static estimates suggest. But they do not pay for themselves. And if tax cuts add to the debt and lead to a crisis, they'll end up costing us far more than what CBO suggests.

Tax cuts, like spending, must be paid for.