Hope and faith only go so far.

Photographer: Peti Kollanyi/Bloomberg

Growth Fantasy of Tax Cuts and Small Government

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Jeb Bush says that if he's elected president he wants to get us to sustained gross domestic product growth of 4 percent a year. I'm highly skeptical, and I'm far from the only one. But there are some true believers, who think that if we just do the right structural reforms, we can get there. University of Chicago economist John Cochrane, for example, has a long list of structural reforms that he thinks will do the trick.

Now some of these are probably good ideas, and some are probably bad. But what we really lack is any idea of the quantitative impact of any given reform. A good idea might produce a 1 percentage point increase in growth for three years, or a 0.01 percentage point bump for three months. A lot of the belief that we can reform our way to sustained higher growth really boils down to faith and hope.

There are many cases where that faith and hope has turned out not to be justified. For example, there is the case of the ALEC rankings. ALEC is short for the American Legislative Exchange Council, a think tank comprised of state senators and representatives from a number of large corporations in industries such as energy and pharmaceuticals. They employ a number of economists, including Arthur Laffer, the famous proponent of supply-side economics.

Every year, ALEC produces a report called "Rich States, Poor States," in which it ranks states according to how business-friendly their policies are. ALEC claims that the policies it advocates determine which states will grow and which won't. From the report's website:

Rich States, Poor States not only identifies these policies but also makes sound research-based conclusions about which states are poised to achieve greater economic prosperity and those that are stuck on the path to a lackluster economy.

Alec lists 15 factors that it claims boost state growth rates. These boil down to low taxes, low levels of government spending and light regulation. In other words, these policies are similar to the ideas John Cochrane describes, and that pro-free-market economists have been promising us will boost growth since time immemorial. It's a simple prescription: shrink the state, cut taxes and the economy will grow. 

But do the policies work? Empirical evidence suggests that they don't deliver. Menzie Chinn, an economist at the University of Wisconsin, applied his formidable statistics skills to investigating the impact of ALEC's rankings on actual state growth levels. What he found was startling -- the ALEC rankings didn't predict a state's growth within one year, three years or six years. In other words, if having ALEC-endorsed policies makes a state grow faster, either it must take a very long time, or the effect is too small to measure. 

In fact, when Chinn controls for a number of other variables, such as urbanization rates, weather and access to waterways, he finds that there may even be a negative relationship between the ALEC rankings and growth -- in other words, states that ALEC claims have more business-friendly policies might actually grow more slowly! 

Chinn isn't the only one who has analyzed the ALEC rankings. The Iowa Policy Project, a smaller rival think tank, conducted its own analysis and reached the same conclusion as Chinn. They investigated ALEC's factors individually, and found that none of them had much of a relationship to growth. 

What about other measurements of business-friendly policy? These fare slightly better. In 2013, economists Jed Kolko, David Neumark and Marisol Mejia analyzed 10 different indexes of state business climate, and found that two factors did predict higher growth. These are 1) simpler corporate tax codes and 2) less spending on welfare and other transfer payments. But the effect of these policies on growth was very small. 

So what we're seeing is that supposedly pro-business policies, of the type constantly urged on us by conservative think tanks and rightward-leaning economists, are just not that effective in generating growth. Yes, there are a few things we can do. We can simplify the corporate tax code, and -- if we aren’t worried about the social harm to vulnerable populations -- we can cut transfer payments. But even these will give only a slight fillip to growth. Most of the low-hanging fruit, in terms of business-friendly policies, has already been picked. 

In other words, don't believe that Jeb Bush can deliver on his 4 percent growth promise simply by lowering taxes and easing regulation. As for the more radical steps John Cochrane suggests, such as ending agricultural subsidies, eliminating occupational licensing and rolling back most labor law, we should get the data before we start slashing. It seems likely that many of these radical free-market policies would deliver a lot of economic and social disruption for very little actual growth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net