Less is more? Why Bush sees higher revenues as vindicating his tax cuts, but it is real?
Less is more? Why Bush sees higher revenues as vindicating his tax cuts
By Krishna Guha and Holly Yeager
Copyright The Financial Times Limited 2006
Published: July 19 2006 03:00 | Last updated: July 19 2006 03:00
Dick Cheney and Donald Rumsfeld may not instantly have realised it. But when, back in 1974, they dined with the economist Arthur Laffer at the Two Continents restaurant in Washington DC, they were witness to a moment of economic history.
Mr Laffer sketched on a napkin his now-famous theory that tax revenues could rise if taxation rates were cut.
Three decades later, Mr Cheney is vice-president, Mr Rumsfeld is another key ally of President George W. Bush as defence secretary and there are again echoes of what became known as the "Laffer curve" argument as the administration and its Republican supporters seek to claim credit for an unexpected surge in US tax revenues.
With November midterm congressional elections in sight, the White House is keen to point out that tax receipts will be $115bn (£63bn, €92bn) higher and the budget deficit $127bn lower than its economists forecast six months ago.
The new estimates are also much higher than earlier forecasts by the non-partisan Congressional Budget Office. Indeed, analysis based on the CBO figures suggests that the positive revenue surprise this year will be the third biggest, relative to the size of the economy, in a quarter of a century.
An unanticipated tax bonanza is good news for any party in power facing an awkward encounter with the voters. But for Republicans it is particularly potent because - superficially at least - it appears to validate the central article of conservative political faith expounded by Mr Laffer: that tax cuts stimulate growth and, to a significant degree, pay for themselves through increased economic activity and compliance.
On the day the new forecasts were released, Mr Bush declared: "Some people in Washington say we had to choose between cutting taxes and cutting the deficit . . . Today's numbers show that was a false choice. The economic growth fuelled by tax relief has helped send our tax revenues soaring."
Republican congressional leaders joined in, scenting an opportunity to shift the terms of the debate ahead of the November vote. "The fact is, keeping taxes low - coupled with fiscal discipline and strong economic growth - is an effective blueprint for reducing and eliminating the deficit," said John Boehner, majority leader in the House of Representatives. Deborah Pryce, chairman of the House Republican Conference, credited Bush tax cuts with "significantly boosting revenue and shrinking the deficit".
Democrats were unanimous in rebuttal, however. "Only Washington Republicans would think a $300bn deficit is good news," said Harry Reid, Democratic leader in the Senate. Kent Conrad, the top Democrat on the Senate budget committee, added: "The nation's debt continues to pile up at an unsustainable rate and the Bush administration has done nothing but make it all much worse."
The political rhetoric is noticeably detached from the economic analysis. Not a single credible economist endorses the extravagant claims of some Bush administration supporters that the new figures show tax cuts pay for themselves.
Martin Feldstein, professor of economics at Harvard and former chairman of Ronald Reagan's presidential council of economic advisers, is perhaps the most respected advocate of supply-side effects. He says his work suggests that following an across-the-board income tax cut, behavioural changes such as a willingness to work harder in more demanding roles "cause you to recover about one-third of the revenue you would otherwise lose". Most others believe the effects are considerably smaller.
But the new forecasts have prompted serious debate as to what the numbers signify and the extent to which they might in any part be attributable to the tax cuts of 2001 and 2003.
Any objective analysis has to start with the tax numbers themselves. Tax receipts, which had been surprisingly weak even after allowing for the tax cuts, rose 14.5 per cent last year and are expected to grow 11.5 per cent this year.
Jason Furman, who was economic policy director for John Kerry, Democrat contender in the 2004 presidential election, says "it is a surprise". But he argues that revenues are hard to predict and Bill Clinton's administration faced a similarly large and unexpected bonanza between 1996 and 1997 after raising taxes.
The main reason that tax revenues are rising is the rapidly growing economy. Rob Portman, director of the Office of Management and Budget, says this is in part due to tax policy. Tax cuts "worked to generate economic growth, and economic growth is now working to raise revenues".
There are two ways in which tax cuts can stimulate growth: in the near term, by generating extra demand, and in the long run, by encouraging increased supply of labour or capital.
Economists are generally sceptical about demand management. But it is plausible, at least, that the Bush tax cuts - which took effect after the bursting of the dotcom bubble, when the Federal Reserve cut interest rates to 1 per cent and was arguably close to running out of ammunition - helped ensure the US escaped a debt-deflation trap.
Henry Aaron, a fellow at the Brookings Institution and a former special assistant to Mr Clinton, says: "It was good timing, whether intended or not." His complaint is that well-targeted measures could have achieved the same effect at vastly lower long-term cost in lost revenues. In any event, with the economy back on track, there is no demand-side case for making the tax cuts permanent, as the Bush administration is seeking to do.
Moreover, with interest rates back in more normal territory and presumably higher than they would be if the deficit was lower, fiscal stimulus from 2001 and 2003 is probably not providing much of a lift to growth and revenues in 2006.
This leaves the supply-side story. From a supply-side perspective, says Dan Mitchell, a fellow at the Heritage Foundation, "not all tax cuts are created equal". The 2001 Bush tax cuts were big but not immediately focused on marginal tax rates - the key to supply-side incentives. The 2003 tax cuts were smaller but implemented immediate cuts in marginal rates on income and capital. Chris Edwards, director of tax policy at the Cato Institute, says research shows cutting taxes on capital produces a bigger supply side response than cutting taxes on labour income.
Higher than expected capital gains tax receipts would be consistent with the tax figures, which show "non-withheld" taxes (including capital gains, bonuses and profits of unincorporated businesses) rising much more rapidly than "withheld" taxes (on wage income). But the bonanza may in large part reflect the unlocking of past capital gains under a new lower rate. This would be a one-off gain in tax terms, although it could produce onÂÂgoing economic benefits.
To the extent that lower taxes on capital boosted the stock market - a thesis disputed by some researchers - this generates genuine additional gains. Glenn Hubbard, dean of Columbia Business School and a former chairman of Mr Bush's council of economic advisers, says: "I did think it would have quite a significant effect." But even he says it would not be big enough in the early years to explain the bulk of the surge in tax revenues.
On the labour supply side, neither hours worked nor workforce participation rates or changes in pre-tax income are unusually high, or have increased unusually rapidly since 2001 and 2003, with the arguable exception of wages for high-income earners.
By contrast, there are plausible explanations for the bumper tax revenues that have relatively little to do with supply-side economics. As Mr Furman and Peter Orszag, a former Clinton administration official now at Brookings, both point out, corporate profits are remarkably high as a share of gross domestic product, and some of this is showing up in higher taxes. Corporate income taxes are forecast to rise 19 per cent this year.
If profits of non-incorporated businesses - which file individual income tax returns - are high for the same reasons that corporate profits are high, this could explain a large part of the surprise 15.2 per cent rise in individual income tax revenues.
Rising income inequality, too, might be helping to lift tax revenues, with wage growth concentrated among high-earners who pay tax at a higher rate. Alternatively it could be random noise. Doug Holtz-Eakin, a former director of the CBO, says: "I do not think there is any real reason to completely dismiss the notion that some of the surprise, over and above the effect of a strong economy, could come from the supply side." But he admits "there is nothing definitive" he can point to in the numbers to bear that out.
Economists who support the tax cuts point out that they were never expected to deliver rapid results in the short term, and long-run gains should be measured in terms of overall economic benefit, not just tax numbers. That debate remains open, although opponents say the net impact is likely to be negative, with efficiency gains more than offset by higher interest rates.
The Treasury's own estimate of a 0.7 per cent gain in GDP is quite small. Meanwhile, economists agree that the data is not yet available to provide any rigorous analysis of the sources of the tax surprise.
Says Mr Orszag: "There is a tension between academic certainty and political expediency." This, though, will not stop Republicans from trying to make tax cuts a big feature of the November campaign. Karl Rove, the president's top political strategist, put the tax cuts at the centre of the party's campaignstrategy. "The fundamental question confronting us in Washington is, 'how do we keep thiseconomic recovery going?'" Mr Bush said during a recent campaign stop in Indiana. "The first thing is: make the tax cutspermanent."
Democrats are largely avoiding discussion of tax cuts, preferring to focus on the minimum wage, cutting college costs, Social Security, healthcare and petrol prices.
In a Los Angeles Times/Bloomberg poll late last month, 61 per cent said the tax cuts of the last few years had not benefited them personally. "The sophisticated voter can't look at only one side of the equation," says Bernadette Budde, who monitors congressional elections for Bipac, a pro-business political action committee. "If tax cuts mean inferior education and no money for better roads, they're reluctant to accept that kind of tax cut."
But Mr Bush does not appear ready to change a message that he believes crucially differentiates him from his opponents. "Cutting the taxes works. It makes this economy strong," he said at a Wisconsin campaign stop this month, adding: "It's just a philosophical difference."
By Krishna Guha and Holly Yeager
Copyright The Financial Times Limited 2006
Published: July 19 2006 03:00 | Last updated: July 19 2006 03:00
Dick Cheney and Donald Rumsfeld may not instantly have realised it. But when, back in 1974, they dined with the economist Arthur Laffer at the Two Continents restaurant in Washington DC, they were witness to a moment of economic history.
Mr Laffer sketched on a napkin his now-famous theory that tax revenues could rise if taxation rates were cut.
Three decades later, Mr Cheney is vice-president, Mr Rumsfeld is another key ally of President George W. Bush as defence secretary and there are again echoes of what became known as the "Laffer curve" argument as the administration and its Republican supporters seek to claim credit for an unexpected surge in US tax revenues.
With November midterm congressional elections in sight, the White House is keen to point out that tax receipts will be $115bn (£63bn, €92bn) higher and the budget deficit $127bn lower than its economists forecast six months ago.
The new estimates are also much higher than earlier forecasts by the non-partisan Congressional Budget Office. Indeed, analysis based on the CBO figures suggests that the positive revenue surprise this year will be the third biggest, relative to the size of the economy, in a quarter of a century.
An unanticipated tax bonanza is good news for any party in power facing an awkward encounter with the voters. But for Republicans it is particularly potent because - superficially at least - it appears to validate the central article of conservative political faith expounded by Mr Laffer: that tax cuts stimulate growth and, to a significant degree, pay for themselves through increased economic activity and compliance.
On the day the new forecasts were released, Mr Bush declared: "Some people in Washington say we had to choose between cutting taxes and cutting the deficit . . . Today's numbers show that was a false choice. The economic growth fuelled by tax relief has helped send our tax revenues soaring."
Republican congressional leaders joined in, scenting an opportunity to shift the terms of the debate ahead of the November vote. "The fact is, keeping taxes low - coupled with fiscal discipline and strong economic growth - is an effective blueprint for reducing and eliminating the deficit," said John Boehner, majority leader in the House of Representatives. Deborah Pryce, chairman of the House Republican Conference, credited Bush tax cuts with "significantly boosting revenue and shrinking the deficit".
Democrats were unanimous in rebuttal, however. "Only Washington Republicans would think a $300bn deficit is good news," said Harry Reid, Democratic leader in the Senate. Kent Conrad, the top Democrat on the Senate budget committee, added: "The nation's debt continues to pile up at an unsustainable rate and the Bush administration has done nothing but make it all much worse."
The political rhetoric is noticeably detached from the economic analysis. Not a single credible economist endorses the extravagant claims of some Bush administration supporters that the new figures show tax cuts pay for themselves.
Martin Feldstein, professor of economics at Harvard and former chairman of Ronald Reagan's presidential council of economic advisers, is perhaps the most respected advocate of supply-side effects. He says his work suggests that following an across-the-board income tax cut, behavioural changes such as a willingness to work harder in more demanding roles "cause you to recover about one-third of the revenue you would otherwise lose". Most others believe the effects are considerably smaller.
But the new forecasts have prompted serious debate as to what the numbers signify and the extent to which they might in any part be attributable to the tax cuts of 2001 and 2003.
Any objective analysis has to start with the tax numbers themselves. Tax receipts, which had been surprisingly weak even after allowing for the tax cuts, rose 14.5 per cent last year and are expected to grow 11.5 per cent this year.
Jason Furman, who was economic policy director for John Kerry, Democrat contender in the 2004 presidential election, says "it is a surprise". But he argues that revenues are hard to predict and Bill Clinton's administration faced a similarly large and unexpected bonanza between 1996 and 1997 after raising taxes.
The main reason that tax revenues are rising is the rapidly growing economy. Rob Portman, director of the Office of Management and Budget, says this is in part due to tax policy. Tax cuts "worked to generate economic growth, and economic growth is now working to raise revenues".
There are two ways in which tax cuts can stimulate growth: in the near term, by generating extra demand, and in the long run, by encouraging increased supply of labour or capital.
Economists are generally sceptical about demand management. But it is plausible, at least, that the Bush tax cuts - which took effect after the bursting of the dotcom bubble, when the Federal Reserve cut interest rates to 1 per cent and was arguably close to running out of ammunition - helped ensure the US escaped a debt-deflation trap.
Henry Aaron, a fellow at the Brookings Institution and a former special assistant to Mr Clinton, says: "It was good timing, whether intended or not." His complaint is that well-targeted measures could have achieved the same effect at vastly lower long-term cost in lost revenues. In any event, with the economy back on track, there is no demand-side case for making the tax cuts permanent, as the Bush administration is seeking to do.
Moreover, with interest rates back in more normal territory and presumably higher than they would be if the deficit was lower, fiscal stimulus from 2001 and 2003 is probably not providing much of a lift to growth and revenues in 2006.
This leaves the supply-side story. From a supply-side perspective, says Dan Mitchell, a fellow at the Heritage Foundation, "not all tax cuts are created equal". The 2001 Bush tax cuts were big but not immediately focused on marginal tax rates - the key to supply-side incentives. The 2003 tax cuts were smaller but implemented immediate cuts in marginal rates on income and capital. Chris Edwards, director of tax policy at the Cato Institute, says research shows cutting taxes on capital produces a bigger supply side response than cutting taxes on labour income.
Higher than expected capital gains tax receipts would be consistent with the tax figures, which show "non-withheld" taxes (including capital gains, bonuses and profits of unincorporated businesses) rising much more rapidly than "withheld" taxes (on wage income). But the bonanza may in large part reflect the unlocking of past capital gains under a new lower rate. This would be a one-off gain in tax terms, although it could produce onÂÂgoing economic benefits.
To the extent that lower taxes on capital boosted the stock market - a thesis disputed by some researchers - this generates genuine additional gains. Glenn Hubbard, dean of Columbia Business School and a former chairman of Mr Bush's council of economic advisers, says: "I did think it would have quite a significant effect." But even he says it would not be big enough in the early years to explain the bulk of the surge in tax revenues.
On the labour supply side, neither hours worked nor workforce participation rates or changes in pre-tax income are unusually high, or have increased unusually rapidly since 2001 and 2003, with the arguable exception of wages for high-income earners.
By contrast, there are plausible explanations for the bumper tax revenues that have relatively little to do with supply-side economics. As Mr Furman and Peter Orszag, a former Clinton administration official now at Brookings, both point out, corporate profits are remarkably high as a share of gross domestic product, and some of this is showing up in higher taxes. Corporate income taxes are forecast to rise 19 per cent this year.
If profits of non-incorporated businesses - which file individual income tax returns - are high for the same reasons that corporate profits are high, this could explain a large part of the surprise 15.2 per cent rise in individual income tax revenues.
Rising income inequality, too, might be helping to lift tax revenues, with wage growth concentrated among high-earners who pay tax at a higher rate. Alternatively it could be random noise. Doug Holtz-Eakin, a former director of the CBO, says: "I do not think there is any real reason to completely dismiss the notion that some of the surprise, over and above the effect of a strong economy, could come from the supply side." But he admits "there is nothing definitive" he can point to in the numbers to bear that out.
Economists who support the tax cuts point out that they were never expected to deliver rapid results in the short term, and long-run gains should be measured in terms of overall economic benefit, not just tax numbers. That debate remains open, although opponents say the net impact is likely to be negative, with efficiency gains more than offset by higher interest rates.
The Treasury's own estimate of a 0.7 per cent gain in GDP is quite small. Meanwhile, economists agree that the data is not yet available to provide any rigorous analysis of the sources of the tax surprise.
Says Mr Orszag: "There is a tension between academic certainty and political expediency." This, though, will not stop Republicans from trying to make tax cuts a big feature of the November campaign. Karl Rove, the president's top political strategist, put the tax cuts at the centre of the party's campaignstrategy. "The fundamental question confronting us in Washington is, 'how do we keep thiseconomic recovery going?'" Mr Bush said during a recent campaign stop in Indiana. "The first thing is: make the tax cutspermanent."
Democrats are largely avoiding discussion of tax cuts, preferring to focus on the minimum wage, cutting college costs, Social Security, healthcare and petrol prices.
In a Los Angeles Times/Bloomberg poll late last month, 61 per cent said the tax cuts of the last few years had not benefited them personally. "The sophisticated voter can't look at only one side of the equation," says Bernadette Budde, who monitors congressional elections for Bipac, a pro-business political action committee. "If tax cuts mean inferior education and no money for better roads, they're reluctant to accept that kind of tax cut."
But Mr Bush does not appear ready to change a message that he believes crucially differentiates him from his opponents. "Cutting the taxes works. It makes this economy strong," he said at a Wisconsin campaign stop this month, adding: "It's just a philosophical difference."
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