Deficit Obsession Disorder Watch

Daniel Altman, an economist and columnist for the New York Times recently wrote an article with the title "A Bit of Doodling About a Tax-Cut Danger". I'm not at all impressed by the article, but I suppose that Altman at least admits that it's just doodling. Some excerpts with my comments follow:

EARLY last month, without much fanfare, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates." At a modest seven pages, it didn't elicit the same sort of interest as the budget office's budgetary and economic outlooks. Yet it may be one of the most important government publications in years.

As Douglas J. Holtz-Eakin, the budget office's director, writes in a brief summary at the beginning of the paper, most predictions of the effects of tax-rate changes "do not include the budgetary impact of any possible macroeconomic effects of tax policies." In other words, the predictions don't take into account how tax cuts could affect the overall size of the economy. It is this omission - one often cited by proponents of tax cuts, especially in the White House - that the paper tries to correct.

Perhaps, but it doesn't try very hard to correct that omission. For example, in the CBO paper, the following paragraph appears on page 4:

"In principle, the tax cut could also affect the economy by increasing the level of technological know-how. However, there is not enough evidence on how tax policy affects innovation for CBO to incorporate such effects in this analysis."

While it's probably true that there's not enough data to quantify how much "tax policy affects innovation," many economists believe that there is a significant effect. Indeed, Altman himself identifies this effect as believed to be an important piece of the puzzle by other economists (though he himself disagrees with those other economists) as shown in the following excerpt from an article from Slate that he wrote (emphasis added):

During the Reagan administration, most talk about tax cuts centered on removing disincentives to work. In the years that followed, though, academic economists began to favor a new set of theoretical models where the savings rate took a more prominent role as a determinant of economic growth. In addition, the models suggested that the pace of technological change depended on changes in the size of the capital stock, which can only grow if investors save more. The neoconomists didn't invent these models -—that was the job of theorists whose work sometimes looked more like physics than economics -—but they quickly grasped the implications for policy. They used the models to postulate the following chain reaction:

1. Government cuts tax rates on savings and wealth.

2. Saving by households -—bank accounts, stocks, bonds, etc. -—increases.

3. More money becomes available to American businesses, since they're the ones offering the bank accounts, stocks, bonds, etc.

4. Businesses spend more on machinery, software, and other capital, as well as on research and development.

5. The nation's output of goods and services grows, and technological innovation accelerates.

6. Incomes and living standards rise more quickly for several years and perhaps forever.

Note that step 5 is the step that the CBO model chooses to leave out because they can't quantify it based on available empirical evidence. Leaving out this critical step clearly changes the whole equation. Without it, tax cuts are significantly less beneficial. Sure enough, using the CBO's models without the benefit of increased know how and its corresponding positive effect on growth, Altman can confidently write:

The recent analysis by Mr. Page at the Congressional Budget Office dismisses the idea that tax cuts may actually improve the government's fiscal situation. Even in his most generous scenario, only 28 percent of lost tax revenue is recouped over a 10-year period.

Altman then goes on to write:

Recent experience corroborates this prediction. In the second quarter of 2001, just before the first of President Bush's tax cuts took effect, federal receipts from personal taxes accounted for 10.3 percent of the economy. By the end of the post-recession slump, receipts had dropped to 6.4 percent. But in the third quarter of 2005, with the economy booming, they were still under 7.5 percent - an enormous difference. In dollar terms, federal receipts from personal income taxes, at $802 billion in 2004, are still lower than they were in 1998 ($826 billion) and much lower than in 2001 ($994 billion).

The numbers are correct, and the picture painted seems at least partly correct - the tax rate cuts have cost the government money - so far. But what about that "economy booming" phrase? Might the economy be booming because of the process outlined above by the supply sider neoconomists that Altman loathes? All projections (CBO, etc.) show record federal revenues by the end of 2007, even excluding social security revenues (including social security, revenues will probably be higher this year). Might it be that the additional productivity growth due to the tax rate cuts will eventually cause higher government revenue than would have otherwise been collected without the tax cuts? The supply siders say YES! YES! YES! The socialist economists such as Altman and Krugman say NO! NO! NO! Who's right? Who knows? We'll know when we've collected enough data in about 10,000 years. In the mean time, you have to take your best guess. My best guess, based on the models I create, is that the supply siders are right.

Altman does admit to a little bit of a short term upside:

On the other hand, Mr. Page estimates that gross national product would be an average of about 1 percent higher, adjusted for prices, as a result of the 10 percent cut in tax rates. Based on the August forecast by the budget office, that extra income would come to slightly less than $1.5 trillion in today's dollars. In Mr. Page's analysis, consumers would also pay about $900 billion less in taxes. Over all, they'd have up to $2.4 trillion more to spend during the decade he analyzed.

THE tax cuts' benefits would be whatever pleasures that individuals could attain with that money. The initial costs would be the absence of whatever useful things the government would have done with the $200 billion it had to pay in interest. The later costs would be the pleasures or useful things the nation would have to forgo in the future, when it was time to pay its debts.

For many people, this may sound like a slam dunk, especially if they don't care what happens after the next decade.

But Altman ends with a rather odd conclusion:

But keep going in this direction [of cutting taxes], and pretty soon the federal government would be collecting no taxes and trying to borrow enough money to cover its entire budget. It's doubtful that many people would want to lend to a government with no source of revenue for 10 years.

Call it the Altman Curve: the total amount that people will actually lend you rises with the amount you plan to borrow, until you reach a crucial point, after which it falls to zero. The United States is now on the left side of the curve. If Congress keeps cutting taxes by more than it cuts spending, the nation will eventually move to the right side, which, of course, is the wrong side.

It looks to me that he's just saying that if the government eventually doesn't collect any taxes at all, and borrows its entire budget, it would be a problem. No kidding. But that has no relevance regarding current tax rates. Somehow I don't think that the Altman Curve is going to be anywhere near as famous as the Laffer Curve - and for good reason.