Thursday, November 25, 2010

Do Capital Gains Tax Cuts Increase Revenue?

At the end of my November 8th post, I asked for anyone who knows of an economic study that purports to show that any income tax cut has paid for itself to please post a link to it. On November 18th, I received the following reply:

I'm not an economist of any flavor, but I was wondering what you thought of the article by Stephen J Entin from the Institute for Research on the Economics of Taxation that I've linked below. He appears to argue that increased capital gains tax should decrease net federal revenues.

Any thoughts appreciated.

The rest of this post will attempt to answer this reply:

My request at the end of my November 8th post did refer to income tax cuts, not capital gains tax cuts and those are the primary focus of my analysis which I referenced there. The only involved analysis of capital gains tax cuts that I have done are in my prior posts, here, here, and here. Following is my chief conclusion from that relatively short analysis:

The above discussion points to how difficult it is to study the relationship between capital gains tax rates and revenues. Hence, it is not intended to show a simple relationship but rather to show the problems with claims of simple relationships derived from looking at a few changes in the capital gains tax rate. That said, I did notice one interesting relationship in the data. From 1954 to 1982, there appeared to have been something of a positive correlation between the average capital gains tax rate and capital gains revenue. That is, they both tended in increase or decrease at the same time. After 1982, there appeared to be much more volatility in both the average tax rate and revenue and any obvious positive correlation disappeared. This would suggest that a more stable average tax rate might be desirable. This would lessen the need for investors to concern themselves with the timing of their stock transactions and allow them to concern themselves only with the long-term value of the investments themselves. If at any point that it is decided that the tax rate needs to be changed, it would likely be wise to phase in the change slowly.

Following is a graph of the data that this paragraph is referring to:

I did take a quick look through the paper you referenced and do have a few thoughts. First of all, I had some comments on the second paragraph which reads as follows:

However, taxpayers react to higher tax rates by earning and reporting less income. Higher taxes on capital retard capital formation and reduce wages across the board. The particular tax increases that the Congress and the Administration are most likely to adopt would damage the economy and reduce the tax base. In fact, they are likely to result in lower federal revenues, and larger budget deficits.

Except for the word "likely", these statements seems a bit absolute. In any event, this proposed effect is possibly countered by other effects. Consider the following excerpt from an article titled "Policy Points: Experts Agree That Capital Gains Tax Cuts Lose Revenue":

To raise revenue over the long run, capital gains tax cuts would need to have extraordinary huge, positive effects on saving, investment, and economic growth that virtually no respected expert or institution believes they have. In fact, experts are not even sure that the long-term economic effects of these capital gains tax cuts are positive rather then negative.

One reason is that preferential tax rates for capital gains encourage tax sheltering, by creating incentives for taxpayers to take often-convoluted steps to reclassify ordinary income as capital gains. This is economically unproductive and wastes resources. The Urban-Brookings Tax Policy Center’s director Leonard Burman, one of the nation’s leading tax experts, has explained, “shelter investments are invariably lousy, unproductive ventures that would never exist but for tax benefits.” Burman has concluded that, “capital gains tax cuts are as likely to depress the economy as to stimulate it.”

Secondly, I did notice that the paper seems to concede that it is in disagreement with the Treasury and Joint Tax Committee of the Congress. On page 3, it states:

The Office of Tax Analysis at the Treasury and the staff of the Joint Tax Committee of the Congress estimate revenues for the Federal budget. They also estimate changes in revenue associated with proposed changes in tax policy. They base their revenue forecasts on an assumed underlying state of the economy (the baseline economic forecast). The economic baseline specifies the amounts of total output, employment, capital, and the various types of income associated with them (the macro-economic conditions).

The revenue estimates of a proposed tax change are conducted on the assumption that the macro-economic baseline, with its aggregate levels of income and output, labor and capital, is fundamentally unchanged. This is called static revenue estimation. By contrast, estimation that allows for tax changes or other budget changes to affect macro-economic conditions, such as the size of the economy and the level of income, is called dynamic revenue estimation.

This disagreement is also mentioned by the CBPP article which also mentions the non-partisan Congressional Budget Office (CBO) and the Administration’s Office of Management and Budget as estimating that cutting capital gains rates reduces revenues over the long run. The paper does suggest in the excerpt above that this disagreement is because it is using a presumedly better dynamic revenue estimation versus static revenue estimation being used by the other studies. However, the CBO did do at least one study using various supply-side models in 2004 to analyze President Bush's proposals which included extending the tax cuts. As can be seen in the summary of that study at this link, those models estimated a significant cost just as did the conventional model. Now those proposals did include more than a capital gains tax cut. Still, it does show a case where the use of dynamic models by the CBO has had no significant effect on the estimated costs.

Thirdly, the conclusions of the paper seem to be based strictly on a theoretical model, the Cobb Douglas production function described starting on page 36. Although this model was doubtlessly analyzed against real data, the paper does not appear to do any analysis of recent data. Hence, I could only search for critiques of this model. This link states that the "Cobb-Douglas production function was largely abandoned after 1961" and there are some criticisms listed in the
Wikipedia entry for the model. It's not an easy thing to judge these criticisms but neither is it easy to judge the Cobb-Douglas production function itself.

In any event, the paper does seem to agree that there is a significant difference between the effect of income tax cuts and capital gains tax cuts. The following excerpt is from page 22:

The supply of labor is rather inelastic. Many primary workers (the main breadwinners in the households) are employed by others, and have limited ability to vary their hours worked (set by their employers) or the degree to which they participate in the work force (each family needs at least one breadwinner). Their hours worked do not vary a lot as wages rise or fall (so the supply curve in Chart 1 is steeply vertical.) Such workers are assumed to bear most of any taxes imposed on labor, including the income tax and the payroll tax, both the employee and employer shares. Secondary workers in the family, the self-employed, teenagers, and wealthier individuals have somewhat more flexibility in deciding whether or not to work, and how many hours to offer, but even they bear most of the tax on their labor income.

The effect of taxes on capital is quite different. The quantity of capital is far more sensitive to taxes than is the quantity of labor. (Its supply curve is more nearly horizontal.) It is easy and enjoyable to consume instead of save, and quite possible to invest abroad instead of in one’s own country. If the after-tax rate of return on saving and investment in the United States is driven down by an increase in the tax rate, U.S. capital formation may be curtailed, or shifted to other countries. The same phenomenon occurs within the country. When there is a tax increase on capital in any one jurisdiction, the amount of plant, equipment, and buildings in that region shrinks. As the capital becomes scarce, the rate of return on the remaining capital rises, until it is again earning a normal rate of return, after tax.

So this paper does not seem to be in any way suggesting that income tax cuts pay for themselves. Hence, I am still yet to find a single economic study that purports to show evidence that any income tax cut has ever paid for itself and would be interested in any that someone could post a link to. However, I am also interested in any additional studies that make that claim about capital gains tax cuts. Anyhow, I hope these thoughts were helpful to the commenter who asked for them. Feel free to leave any additional comments or questions.

Monday, November 8, 2010

Do Tax Cuts Increase Revenue?

On November 7th, David Stockman and Mike Pence appeared on This Week with Christiane Amanpour to debate tax cuts. David Stockman was a budget director for President Ronald Reagan and Mike Pence is a Congressman and has been the Chairman of the House Republican Conference for the past two years. A video of the tax cut debate can be found on the This Week website and a transcript can be found at this link. Following is an excerpt from that transcript:

PENCE: Before we get -- look, David Stockman is, you know, he's a really famous guy and a thoughtful guy. I just disagree with him vehemently and I, frankly, have for about 30 years. David believes that every tax increase equals a revenue increase, but that's not true. Anybody who is familiar with the historical data from the IRS knows that raising income tax rates will likely actually reduce federal revenues.

AMANPOUR: Let me ask David...

PENCE: So if we raise taxes, the American people are very likely going to -- the top 1 percent are going to send less money to Washington, D.C., and that will never get us out of this...


STOCKMAN: I just have to respectfully disagree. You will have some loss of revenue because some activity or transactions won't happen, but if you raise taxes on paper by $100 billion, maybe you'll get $90 billion or $85 billion. But it's just common sense fact that, when you raise the rates, you get more revenue. Normally, it's a bad thing to do. But we are in such dire shape that we have no choice but to accept the negative trade-off of some harm to the economy to start paying our bills. Otherwise, we're dependent on the Chinese, we're dependent on OPEC, we're dependent on a bunch of hedge fund guys to buy our debt, and this game is about over.

Pence states that "raising income tax rates will likely actually reduce federal revenues". This is in reference to the proposal to let all or part of the Bush tax cuts expire at the end of this year. The logical companion to this argument is the old supply-side claim that tax cuts increase revenues above what they would have been otherwise. I have looked at this argument and posted an analysis of it at this link. I could find nothing in the actual numbers to support this claim. In fact, I have asked supply-siders for years to provide the link to one credible economic study that purports to give evidence that supports this claim. As of yet, I have received none.

So far, every economic study that I have found that addresses the issue refutes the claim that tax cuts increase revenue. For example, there is a study titled "Dynamic Scoring: A Back-of-the-Envelope Guide" that was done by N. Gregory Mankiw and Matthew Weinzier. Mankiw was the chairman of President Bush's Council of Economic Advisors from 2003 to 2005. You can find a summary of the study at this link. It gives the following key quote at the top:

"In the long run, about 17 percent of a cut in labor taxes is recouped through higher economic growth. The comparable figure for a cut in capital taxes is about 50 percent."

This pretty much agrees with Stockman's statement that 10 or 15 percent of the revenue expected from a tax increase might be lost due to a decrease in activity or transactions. Both Stockman's statement and the quote above agree with the usual concept that a cut in the tax rate will lose that same percentage of revenue but that some of that loss will be recouped by higher economic growth. However, there are additional effects of tax cuts, negative as well as positive. Following is an excerpt from page 115 of the book "The Coming Generational Storm", co-written by economist Laurence Kotlikoff:

...For tax cuts to raise revenues, pretax labor earnings have to rise by a larger percentage than the tax rate falls.

There are two competing forces at play in determining whether pretax earning rise, stay the same, or fall. On the one hand, workers may say to themselves, "Boy, now that taxes are lower, I can work less and still receive the same after tax pay. I'm going to cut back my workweek." On the other hand, they may say, "Boy, now's a good time to work more and earn more because taxes are lower on every extra dollar I earn". Economists call the first of these reactions the income effect. They call the second reaction, the substitution or incentive effect.

Some of the best labor economists in the country have spent their lifetimes measuring the income and substitution effects. The broad consensus of these experts is that the two effects are roughly offsetting. This means that if wage tax rates are cut by, say 15 percent, tax revenues will fall by 15 percent.

Similarly, there are studies that suggest that certain tax increases can actually promote an increase in economic growth. An example is a study titled "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks" by Christina and David Romer. Christina Romer recently resigned as the chairwoman of President Obama’s Council of Economic Advisers but will become a member of the President's Economic Recovery Advisory Board. The study found that "deficit-driven tax increases" have had a positive effect on economic growth. The following excerpt from page 14 describes these increases:

The figure makes clear that while deficit-driven tax increases have occurred throughout the postwar era, they were most prevalent in the early and mid-1980s. Many of these deficit-driven tax actions were related to Social Security: of the 26 actions in the category, 15 were designed to deal with the long-run solvency of the Social Security system. The Social Security Amendments of 1977 and 1983, in particular, were major tax actions that raised taxes in a number of steps and did not simultaneously increase benefits. The largest deficit-driven tax increases not related to Social Security were those contained in the Tax Equity and Fiscal Responsibility Tax Act of 1982, and the Omnibus Budget Reconciliation Acts of 1987, 1990, and 1993. The first two of these were Reagan-era measures; the third was the Bush tax increase that defied his famous "Read my lips: no new taxes" campaign speech; and the fourth was the Rubinomics-defining tax increase of the early Clinton administration.

The following graph from page 59 shows the estimated impact of a tax increase of 1% of GDP on GDP using long-run and deficit-driven tax changes:

The following excerpt from page 23 refers to this figure:

Panel (b) of Figure 6 shows the results for the two types of exogenous changes. For long-run changes, which make up most of this category, the results are quite similar to those for all exogenous changes. For tax increases to deal with an inherited budget deficit, the results are more interesting. The point estimates imply that output does not fall at all following deficit-driven tax increases. The estimated effect peaks at 1.4 percent after two quarters, and then fluctuates around 1 percent. However, there are too few tax changes of this type for the effects to be estimated very precisely. The maximum t-statistic, for example, is just 1.2. Nonetheless, the estimates are suggestive that tax increases to reduce an inherited deficit may be less costly than other tax increases, and they provide no evidence that they have substantial output costs.

The following excerpt from page 38 summarizes these effects:

In Section III, we found that the responses of real GDP to the two subcategories of exogenous tax changes appear to be quite different. The response to a long-run tax increase is negative, large, and highly statistically significant. In contrast, the response to a deficit-driven tax increase is positive, though not significant.

Finally, the following excerpt from the conclusions on page 41 expands on this positive effect:

Finally, we find suggestive evidence that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases. This is consistent with the idea that deficit-driven tax increases may have important expansionary effects through expectations and long-term interest rates, or through confidence.

As I mentioned, I am yet to find a single economic study that purports to show evidence that any income tax cut has ever paid for itself. If anyone who reads this should know of one, please leave a comment with a link to that study. Thanks.

About Me

I became interested in U.S. budget and economic matters back in 1992, the first time that I remember the debt becoming a major issue in a presidential election. Along with this blog, I have a website on the subject at I have blogged further about my motivations for creating this blog and website at this link. Recently, I've been working on replicating studies such as the analysis at this link.

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