CBO Finds Tax Cuts Are Bad for the Economy

In testimony before the Senate Budget Committee last week, CBO Director Douglas Elmendorf quantified the impacts that extending some or all of the 2001 and 2003 tax cuts would have on the economy. CBO looked at both the near-term and in the long-term. The conclusion? CBO estimates that in 2011 and and 2012, any extension (full or partial, permanent or temporary) of the tax cuts would increase real growth (by varying degrees) in the short-term, but by 2020 and 2040, any extension would decrease national income (although by varying degress). The reason? Additional debt-- financing the tax cuts through borrowing will crowd out private investment.

To be exact, extending the tax cuts permanently could reduce GNP in 2020 by as much as 2% and anywhere from 2.5% to 11% by 2040.

CBO looked at four likely scenarios by which the tax cuts could potentially be extended (although others certainly exist). CBO looked at a permanent extension (permanently extend all the tax cuts for all households--keeping marginal tax rates where they are, indexing the AMT to inflation, and reinstating the estate tax in 2011 at 2009 levels), a permanent extension for all except those earning over $250,000 and for individuals earning more than $200,000, a full extension for only two years, and a partial extension for only two years.

As CBO puts it, the ultimate effect of these policies on growth will be the combination of lower tax revenues pushing deficits upward (thereby crowding out investment) on the negative end and the effect of lower tax rates increasing people's savings and work effort on the positive end. Unfortunately, the negative effects from higher deficits and debt are larger than the benefits, making these tax cuts--unless they are offset--a poor public policy choice.

Below is a table summarizing CBO findings on the economic impacts of these four scenarios. For each scenario in each year, CBO provides a "low estimate" and a "high estimate" to reflect a range of the resulting economic impact based on the responsiveness of labor supply to the different tax policies.

^{^ CBO estimates the economic impacts of these scenarios based on changes in Gross National Product (GNP) and not Gross Domestic Product, because GNP is equal to national income, and therefore the most relevant measure of the total economy. As CBO notes: GNP differs from GDP primarily by including the capital income that residents earn from investments abroad and excluding the capital income that nonresidents earn from domestic investment.}

^{* CBO provided separate estimates in 2020 and in the long-term for situations where government spending and tax adjustments are enacted after 2020 to put fiscal policy on a sustainable path. For demonstrative purposes, we chose the spending cut path.}  

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The takeaway: any unpaid-for tax cut extensions are bad not only for the long-term fiscal outlook, but also the long-term economic outlook. The billions (and in some cases, trillions) of dollars of additional debt even in just the next decade will outweigh the supply-side benefits of lower marginal tax rates from these extensions. CBO argues that these tax cut scenarios would lead to a smaller domestically-owned stock of capital as a result of higher budget deficits and required interest payments.

Based on CBO's findings, plans to permanently extend the tax cuts for families earning under $250,000 (the partial extension) would have the biggest negative effect on the economy in the long-term, followed by the plan to permanently extend all the cuts. It should be noted, though, that this measure assumes that fiscal policy would be put back on a sustainable path through other measures (the table and graph above assumes spending cuts).  But winning the growth battle between the two options isn't something to boast about: both scenarios seriously harm the economy.

So now, arguments for extending the tax cuts based on economic reasons no longer have basis. And with high budgetary costs and a weaker economy by the end of the decade, tax cuts would certainly not improve our fiscal outlook. 

Another finding in the CBO report (not included in the table above) is that in the long-term, getting back to a sustainable fiscal path via spending cuts is less damaging to economic growth than large tax increases. While the spending cut path with permanent extensions is projected to reduce 2040 GNP by anywhere from 2 to 4 percent, the tax increase path with permanent extensions is projected to reduce 2040 GNP by 8 to 11 percent. These projections support the claims of Alberto Alesina, an economist at Harvard University, who said that fiscal consolidations based on spending cuts are more conducive to economic growth than those based more on tax increases (although he was talking more about the short- and medium-term). This is not to say, however, that we should solely rely on spending cuts--everything should be on the table.

So the message of the report is that the tax cuts are bad for both our fiscal and economic health by the end of this decade and beyond, and that a temporary extension, in one form or another, would be much less harmful than permanent extensions. As CRFB President Maya MacGuineas has stated before, a two-year temporary extension could be used as a hammer to force fiscal reform. CBO takes it further, showing that temporary options are far less bad for the economy in the long-term.  

But another central element is that if tax cut extensions are being called for on stimulus grounds, CBO shows that these arguments are weak. Other various policies for temporarily reducing taxes or increasing spending would provide bigger boosts to growth and employment in the short-term at lower bugetary cost--a truly win-win scenario. For example, compare a two-year full extension of the tax cuts to a hypothetical temporary payroll tax holiday split between employers and employees. Extending the tax cuts temporarily would cost about $500 billion and we'll consider a payroll tax holiday that would cost $250 billion. Using the mean of CBO's multipliers, we see that the two-year tax cut option would increase output in 2011 by $125 billion, while the payroll tax holiday would increase output by $175 billion. Furthermore, since we can assume that the negative effects of these options in 2020 is solely due to crowding-out effects (since neither policy would be in effect in 2020), the payroll tax holiday would only have half the negative effect of the temporary extension. Thus, a payroll tax holiday would be better in both the short-term and the long-term than a temporary tax cut extension, if policymakers were to enact any sort of stimulative tax relief.

Source: CBO The Economic Outlook and Fiscal Policy Choices

Even though the benefits of the tax cuts are more tangible right now than the negative effects of higher national debt later in the decade, policymakers and voters must still realize that the tax cuts will ultimately hurt the economy if not paid for. Let's hope they'll heed CBO's warning.