Can lowering taxes actually generate more revenue by stimulating economic growth?
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This is the basic argument of "supply side economics", that taxes discourage
economic activity and slow growth so much that lower tax rates would actually lead to more adequate
government revenues because lowering taxes would stimulate growth and hence raise taxable income
and tax revenues. This is not a short-run "stimulus" argument, but rather an argument for how long-term
growth and tax revenues are related; these ideas were first introduced in the 1980s as "supply-side economics."
There is certainly a high level of taxation for which revenues would decline as tax rates are raised. At that point, lowering tax rates would indeed produce more revenue because a) individuals would have fewer incentives to avoid taxable activities, and b) the "tax burden" or economic distortions that slow growth by discouraging labor supply and investments would be lowered and this would increase growth. The important question, however, is whether the theory plays out this way in the real world, given the structure and tax rates that exist in the U.S. economy. Are we operating at tax levels for which this "elastic" response would occur so that lower taxes would actually lead to higher growth? The answer is a decisive no. For example, income tax revenue as a percent of gross national product increased permanently from about 2 percent to about 15 percent in 1942. This very large increase, the only one of this magnitude, had no noticeable effect on the average growth rate of the economy (Stokey and Rebelo 1995). Moreover, in spite of the large Reagan tax cuts in the early 1980s, the growth rate from 1979 to 1989 (the period between successive business cycles), was 3 %, the same as between the two previous business cycles (Krugman 2003). This period was followed by tax increases in the early 1990s under Presidents Bush and Clinton. The result was not a decline in economic growth, but an increase. This high growth is not attributed to the tax increase (there were clearly other factors), but growth in the economy did not slow, and this is difficult to square with the supply-side predictions. More to the point, many detailed and exhaustive scholarly analyses have been performed by academic economists based on statistical analysis and theoretical models, and these have concluded that there is no evidence that, for the U.S. economy, tax reductions or reforms will have a positive effect on U.S. growth rates (e.g., Lucas 1990; Stokey and Rebelo 1995). And studies which have looked at income and tax statistics find that the responsiveness of taxable income to changes in the tax rate is not responsive enough to generate increased revenue by lowering tax rates. Indeed estimates suggest that a 10 percent reduction in the tax would likely lead to an increase in taxable income of only about 4 percent, hence a net decline in revenues of about 6 percent (Gruber and Saez 2000). References Gruber, Jon and Emmanuel Saez, 2000. The elasticity of taxable income: evidence and implications. National Bureau of Economic Research Working Paper 7512. Krugman, Paul, 2003. The tax-cut con. The New York Times Magazine, September 14, 2003. Lucas, Robert E., Jr. , 1990. Supply-Side Economics: An Analytical Review. Oxford Economic Papers, v42, n2 (April 1990): 293-316. Stokey, Nancy L., and Rebelo Sergio, Growth effects of flat-rate taxes. Journal of Political Economy, Vol. 103(3): pp 519-50. ~
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