How do tax cuts affect the economy

how do tax cuts affect the economy

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April 10, 2006

How do Dividend and Capital Gains Tax Cuts Affect the Economy?

In my last posting, here. I commented on the Bush FY 2007 budget proposal for dynamic analysis, to be carried out by a new Division under Treasury's Office of Tax Policy. I noted that dynamic analysis could be subject to manipulation, since the results depend so directly on the assumptions that are made about expected changes in behavior in response to tax changes (and other factors). I also noted the concern mentioned by the Center on Budget and Policy Priorities (CBPP) authors that dynamic analysis may support claims that tax cuts pay for themselves, even though most economists disagree with that notion.

In that light, it is worth examining a recent Treasury report on the impact of capital gains tax cuts, available here. and an analysis of the Treasury report by the CBPP, here .

The Treasury report appears to be written to persuade readers that capital gains tax relief has benefited the entire economy rather than to assess fully the pros and cons in support of the concept. It first addresses the fact that the U.S. tax system taxes corporations as separate entities from their shareholders and baldly claims that "[r]educing the tax rate on capital gains and dividends promotes economic growth." Treasury Report, Executive Summary. The summary goes on to list ways in which the economy has improved since the passage of the 2003 tax act, which occurred about 18 months into the economic recovery. The summary notes the time correlation between increase in the S&P 500, in nonresidential investment, and in real GDP in a way that implies causation (although the text of the report proper acknowledges that many factors are involved and the role, if any, of capital gains and dividends cuts is not clear). The summary then attributes increased employment to "tax relief," including the dividends and capital gains tax cuts as a factor.

After an initial paragraph pointing out the expected inference in the Treasury Report about the impact of the 2003 tax cuts, the CBPP report provides a "more comprehensive look at the evidence." It concludes that "while the dividend and capital gains tax cuts were indeed correlated with the upturn in the recover[y], they were not the cause of the improvement. CBPP report at 1 [emphasis in original]. Treasury's "simple picture of coincident timing", in other words, "omit[ed] many relevant facts."

Some of the issues noted by CBPP are set out below.

  • In early 2003, economic experts such as Federal Reserve Chairman Ben Bernanke, leading economists surveyed by the Wall Street Journal, and the President's Council of Economic Advisors (CEA) predicted accelerated growth, employment, and investment even without additional tax cuts because of various factors favoring economic growth, including very low interest rates.
  • The recovery with the tax cuts has under performed in terms of employment gains what the CEA expected it to be

    able to do without the tax cuts.

"[T]he economic recovery is still below average, relative to other post-World War II recoveries, with respect to growth in GDP, investment, net worth, consumption, employment, and wages and salaries; only corporate profits have grown rapidly. Overall employment growth in this recovery has been slower than during any comparable post-World War II period." CBPP report at 6.

  • The Treasury report appears to attribute the effect of the full $1 trillion in tax relief between 2001-2006 to the investment income tax cuts, but in fact even the entire tax cut package has had less of a short-term economic stimulus than suggested.

"[While] this massive tax-cut infusion probably did have some impact on the economy[,]. the enacted cuts provided relatively little economic stimulus given their very high cost. They were backloaded, were provided to high-income taxpayers who have a lower propensity to consume additional income, or were targeted at encouraging saving, not consumption or immediate investment. [they] 'played a relatively minor role in the economic recovery compared with other factors.' " CBPP report at 6 (quoting Gale & Orszag, Tax Notes Nov. 1, 2004).

  • The economic consensus is that capital gains and dividend tax cuts will work, if at all, over the long term and not as an immediate short-term economic stimulus. CBPP at 2-3. The Treasury report notes that the stock market rose about the same time that the 2003 tax cuts were passed and includes a report by James Poterba suggesting that capital gains and dividends cuts might provide a boost to the stock market. Treasury report at 9. The report notes that many factors contribute to stock prices, but suggests that the investment income tax cuts "likely played an important role." Id. But the Treasury report doesn't even refer to a Federal Reserve study that concluded that the 2003 gains in the stock market were not attributable to the capital gains and dividend tax cuts, noted by the CBPP report. CBPP at 6 (citing Gene Amromin, Paul Harrison, and Steve Sharpe, "How Did the Dividend Tax Cut Affect Stock Prices ?" Federal Reserve Board Discussion Paper, Dec. 2005).

The Treasury report and the CBPP analysis are well worth reading. Disappointingly, the Treasury report appears to have been developed to support a political argument in favor of extending the investment income tax cuts beyond their current 2008 expiration date. It is flawed by suggesting causality because of mere coincident timing, claiming that tax cuts led to a vigorous economic recovery in spite of the fact that the recovery remains weak relative to post-WWII norms, and disregarding relevant information about expectations for economic growth and job development prior to the 2003 tax cut. The result is a too-rosy story of the economic impact of the tax cuts. The CBPP study provides a necessary caution about the limited potential for investment income tax cuts to power an economic recovery.

Source: ataxingmatter.blogs.com

Category: Taxes

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