"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."
Do tax cuts pay for themselves? To a substantial extent, yes, N. Gregory Mankiw and Matthew Weinzierl conclude in their study, Dynamic Scoring: A-Back-of-the-Envelope Guide (NBER Working Paper No. 11000).
Mankiw and Weinzierl note that when the staffs of the Treasury Department or Congressional committees estimate the revenue cost of tax cuts, they traditionally adopt a process known as static scoring. That is, they assume no feedback from tax changes to national income. By contrast, some observers have suggested that tax cuts can generate so much economic growth that they may more than pay for themselves. Most economists are doubtful about either such extreme. The consensus view is that tax cuts indeed influence national income, but not to the extent that they are fully self-financing.
In 2002 Congress undertook the difficult task of "dynamic scoring" of tax policy. This means developing a set of economic models that can be used to estimate the true revenue effect of tax proposals, including the feedback effects of taxes on national income. This task is challenging, because there is little agreement among professional economists about how best to model long-run economic growth and the impact of taxes on the economy.
Mankiw and Weinzierl consider the problem in light of a particular theory of economic growth, called the neoclassical growth model. This theory is the most widely taught model of capital accumulation and long-run growth, as well as a popular tool in scholarly literature in public finance. In this paper, they use the model to show how changes in taxes on capital and labor income affect national income and tax revenue. The model yields simple formulas for how the true dynamic estimates of these revenue effects differ from the traditionally used static estimates. These formulas in turn allow for some illuminating back-of-the-envelope calculations.
The authors begin with the simplest version of the neoclassical growth model, but they also consider various generalizations of the model to see which conclusions are robust. One generalization of the model includes an elastic supply of labor, so that hours worked can respond to economic incentives. Mankiw and Weinzierl find that regardless of labor supply elasticity, if capital and labor tax rates start off at the same level, cuts in capital taxes have greater feedback effects in the long run than do cuts in labor taxes.
According to the researchers, the neoclassical growth model and all of its variants indicate that the dynamic response of the economy to tax changes is substantial. In almost all instances, they find, tax cuts are at least partly self-financing. The authors conduct some simple calculations, plugging in numbers that approximately describe the U.S. economy. They find that, 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 means that the true revenue cost of a cut in capital taxes is only half of the cost estimated with static scoring.
These results depend on a number of key assumptions, which are open to debate. Mankiw and Weinzierl acknowledge that current studies do not afford clear guidance about how best to apply the neoclassical growth model to the actual economy. Economists will need to focus next on evaluating which generalizations of the basic model are the most salient and then on estimating the key parameters. This task, the researchers say, is urgent. In 2003, Congress adopted a rule that requires the Joint Committee on Taxation to analyze the macroeconomic impact of any major tax cut bill before the House votes on such legislation. "One conclusion is impossible to escape," say Mankiw and Weinzierl. "Difficult as it may be, the subject of dynamic scoring should remain a high priority for those economists advising lawmakers on issues of tax policy.
-- Matt Nesvisky