Wednesday, June 08, 2011

New report outlines the stunning effect of tax cuts

Since the 1980s there have been comedians such as Bloomberg's Kevin Hassett who have penned articles with titles such as Laffer Curve Pays Billions If Obama Just Asks - an article repeating that old canard that tax cuts pay for themselves (the 'curve' is an inverted parabola on a graph of tax rates versus tax revenues, as per the graph). Hassett breathlessly puts it:
"The U.S. is about to have the highest corporate tax rate in the developed world because our competitors have noticed that revenue goes up as rates go down."
Never mind, Mr. Hassett, that the Laffer ideology has been thoroughly debunked - so much so that even Greg Mankiw, chairman of former U.S. President George W. Bush's Council of Economic Advisors, referred to people who believe this stuff as "charlatans and cranks." (Read this entertaining account of the Laffer ideology for more on that.) It's easy to see how attractive the Laffer Curve ideology is - as writer Jonathan Chait put it:
In that sloping parabola was the magical promise of that elusive politician's nirvana, a cost-free path to prosperity: lower taxes, higher revenues.
How does the curve stack up against evidence? In short, it doesn't. Empirical study after empirical study finds that lower tax rates tend to lead to lower revenues - though there is admittedly a lot of complexity to this picture - and that at the end of the day tax rates don't matter that much.

Now the U.S. Congressional Research Service has a (newish report) with the thrilling title International Corporate Tax Rate Comparisons and Policy Implications, which makes some interesting observations.

One observation is that although the U.S. statutory tax rate is higher than in other developed economies, the average effective rate is about the same (our friends at Citizens for Tax Justice never tire of pointing out.) And see this latest NY Times Economix blog highlighting how low U.S. taxes are, as a share of GDP.

Then the CRS asks what the effect would be of a rate cut from 35% to 25%. There have been many, many claims that such a rate cut would have stunning effects in terms of increased economic output and so on. The CRS' estimate for the impact. Drumroll ...
estimates for a rate cut from 35% to 25% suggest a modest positive effect on wages and output: an eventual one-time increase of less than two-tenths of 1% of output. Most of this output gain is not an increase in national income because returns to capital imported from abroad belong to foreigners and the returns to U.S. investment abroad that comes back to the United States are already owned by U.S. firms.
Look again at those bits in bold. Stunning. Not only that, but the report estimates the revenue cost of such a tax cut, in isolation, at $1.2- $1.5 trillion over the next 10 years. Revenue feedback effects from increased investment inflows would reduce those revenue costs by just 5%-6%. In other words, there would be relatively little increased investment as a result of tax cuts.

And then a crucial, crucial point.
"It seems unlikely that a rate cut to 25% would significantly reduce profit shifting given these transactions are relatively costless and largely constrained by laws, enforcement, and court decisions."
So often we see the lobbyists arguing that profit-shifting can be tackled by cutting taxes. And this report - though we stress that it is just one report among many, although from a highly reputable source - comes out squarely against the lobbyists.

And there's more.
"Both output gains and revenue offsets would be reduced if other countries responded to a U.S. rate cut by reducing their own taxes. Evidence suggests that the U.S. rate cut in the Tax Reform Act of 1986 triggered rate cuts in other countries."
If you join in the beggar-thy-neighbour race, your neighbour will beggar you in turn.

The report also looks at finding ways to implement a revenue-neutral tax rate cut (i.e. by eliminating all sorts of tax loopholes and so on.)

The CRS has also released other reports, hat tip TaxProf:


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