June 2 (Bloomberg) -- Cutting taxes creates jobs, and raising taxes destroys them. That’s the view of policymakers, from President Barack Obama to his Republican adversaries.
Evidence from the last two decades, however, suggests that conventional wisdom is wrong.
In the five years after a $241 billion tax increase in 1993, which Republicans criticized as the largest ever, the U.S. economy created more than 15 million jobs and grew at an average annual rate of 3.8 percent.
In the five years after President George W. Bush’s 2001 tax cuts -- which reduced marginal rates, raised the child tax credit, phased out the estate tax and gave “marriage penalty” relief to two-income households -- the economy added about 6.5 million jobs and grew at an annual 2.7 percent pace.
“It’s not that simple,” said Phillip Swagel, who served Bush as assistant Treasury secretary for economic policy. “In the short run, yes, if you raise taxes, it’s generally harmful to growth. In the long run, it doesn’t have to be.”
The consequences of raising taxes are a central issue in negotiations between the White House and Republican leaders in Congress over raising the nation’s $14.3 trillion debt ceiling.
In December, when Obama agreed with congressional Republicans to extend Bush’s lower rates, he promised they would “help grow our economy and create jobs.” The president and congressional Democrats now say they want to reduce the deficit with a “balanced approach” of spending cuts and tax increases on the wealthy. Republican leaders reject any higher taxes.
“A tax hike would wreak havoc not only on our economy’s ability to create private-sector jobs, but also on our ability to tackle the national debt,” House Speaker John Boehner said in a May 9 speech to the Economic Club of New York.
Pinpointing the impact of tax policy is hard, economists say. For one thing, it’s impossible to know how the economy would have performed in the absence of the change. Perhaps the Internet-fueled growth of the 1990s would have produced even more jobs if taxes hadn’t been raised. Perhaps the Bush tax cuts kept a bad economy from getting even worse.
Economic growth also is affected by elements other than taxes, including interest-rate policy, the price of oil and other commodities, and the business cycle itself.
“High GDP countries are high tax countries,” said Joel Slemrod, an economist at the University of Michigan’s Ross School of Business. “That doesn’t mean high taxes cause the high GDP.”
Clinton Tax Rates
Slemrod, who served as senior staff economist for President Ronald Reagan’s Council of Economic Advisers, said raising taxes today would be risky because the economy remains fragile. But given the economy’s performance in the 1990s, returning marginal rates to their Clinton-era levels in 2013, as Obama proposes, wouldn’t be, he said.
“It’s just hard to say that’s the kiss of death for economic growth,” Slemrod said.
A 2010 study by a husband-and-wife team of economists at the University of California at Berkeley concluded that raising taxes typically depresses economic output. David Romer and Christina Romer -- the former head of Obama’s Council of Economic Advisers -- concluded that a tax increase of 1 percent of gross domestic product lowers output by about 3 percent of GDP over the next three years.
An International Monetary Fund study in October provided solace for both sides in the debate. It concluded that deficit reduction raises unemployment and lowers output in the short term and is more painful if it primarily relies on tax increases.
Lowering the Debt
Paring public debt, however, eventually reduces the government’s need to borrow, bringing down long-term interest rates and freeing capital for private investment, the study said.
That’s what happened in the 1990s, when the yield on 30-year Treasuries fell from a peak of 8.2 percent in November 1994 to 5.5 percent in January 2001 when Clinton left office.
“We should be extremely wary of anyone making the argument that any tax increase at any time is going to kick the legs out from under the economy,” said Jared Bernstein, who was Vice President Joe Biden’s economic adviser until April. “If you look at the 1990s versus the 2000s, you’d draw the opposite conclusion.”
Comparing 1993 and 2001 is a reminder of the difficulty of economic forecasting: Higher taxes or lower taxes, the results have confounded expectations.
Wrong on Deficit
In January 1994, five months after Clinton signed the Omnibus Budget Reconciliation Act of 1993, the Congressional Budget Office projected a 1999 deficit of $204 billion.
Instead, stronger-than-expected growth flooded the Treasury with revenue. Rather than a deficit, the government ran a $126 billion surplus.
In January 2002, following enactment of Bush’s first tax cut, CBO predicted a 2007 surplus of $166 billion. The actual outcome, after a recession and the Sept. 11 terrorist attacks, was a deficit of about $161 billion.
“The effects of the Bush tax cuts on growth were ambiguous at best,” said Alan Viard, a scholar at the American Enterprise Institute in Washington and a former Federal Reserve Bank of Dallas economist. “They were not much of a poster child for pro-growth tax policy.”
The Bush tax package included provisions such as establishing a 10 percent bracket and doubling the child tax credit, which provided little incentive for additional work or savings, he added.
Washington’s political dialogue over tax increases obscures a distinction being drawn by a growing number of Republicans: Raising tax rates chills growth. Raising revenue by collecting taxes on income that’s now off limits to the taxman doesn’t.
“There’s a difference between taxes and tax rates,” said John Cochrane, a University of Chicago finance professor. “What matters for growth is tax rates. What matters for government solvency is taxes.”
Cochrane said raising tax rates on each extra dollar of income discourages additional work by wealthier individuals who are best-positioned to create jobs.
Yet tax revenue could still be increased by limiting business subsidies, such as for domestic production, or capping individual deductions for mortgage interest, employer-provided health insurance or charitable contributions. In a May 4 New York Times op-ed, Harvard University Professor Martin Feldstein said $278 billion could be raised this year by putting a ceiling on such “tax expenditures.”
Won’t Hurt Growth
That approach “doesn’t discourage effort or entrepreneurship and doesn’t reduce saving and risk taking,” Feldstein, who served as Reagan’s top economic adviser, said in an e-mail. “It therefore doesn’t hurt economic growth.”
In December, a national fiscal commission chaired by onetime Clinton White House Chief of Staff Erskine Bowles and former Senator Alan Simpson, a Wyoming Republican, produced a deficit plan that included higher tax revenue. It recommended devoting $80 billion in new revenue to shrink the deficit in 2015 and $180 billion in 2020 by curbing tax expenditures, such as subsidies for ethanol production.
That drew support from Republicans such as Senators Saxby Chambliss of Georgia and Tom Coburn of Oklahoma.
On April 13, Obama proposed limiting tax deductions for the wealthiest 2 percent of Americans, which he said would increase revenue by $320 billion over 10 years.
“The clear-cut evidence is that, despite the rhetoric, a tax increase that reduced the deficit would actually improve economic growth,” said Martin Sullivan, an economist and contributing editor with Tax Analysts, a nonprofit organization in Falls Church, Virginia.
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