One of the most contentious issues facing the nation is developing a plan to avoid going over the fiscal cliff. Obama desires to let all of the Bush tax cuts expire except for those who make more than $250,000 a year. Republicans argue this would be detrimental to the economy because these people are the “job creators” and their tax breaks improve economic growth for everybody (supply-side economics , aka trickle-down economics).
What does the evidence say?
I. Congressional Budget Office
The non-partisan Congressional Budget Office says there will be no significant negative impact on the economy should the lower rates on the wealthiest Americans be allowed to expire.
“Extending all expiring tax provisions other than the cut in the payroll tax and indexing the AMT for inflation—except for allowing the expiration of lower tax rates on income above $250,000 for couples and $200,000 for single taxpayers—would boost real GDP by about 1¼ percent by the end of 2013. That effect is nearly as large as the effect of making all of those changes in law and extending the lower tax rates on higher incomes as well (which CBO estimates to be a little less than 1½ percent, as noted above), primarily because the budgetary impact would be nearly as large (and secondarily because the extension of lower tax rates on higher incomes would have a relatively small effect on output per dollar of budgetary cost).”
II. Research by Martin Feldstein, Ronald Reagan’s Chief Economic Adviser
I found this research in the first paragraph of this article by Brendan Greeley of Bloomberg BusinessWeek.
“Martin Feldstein and Doug Elmendorf discovered something surprising in 1989. So much so that when they presented it to a National Bureau of Economic Research conference, they titled their paper (PDF) “Budget Deficits, Tax Incentives and Inflation: A Surprising Lesson From the 1983-1984 Recovery.” Feldstein had been Ronald Reagan’s chief economic adviser during that recovery; Elmendorf now runs the Congressional Budget Office. In 1989, they were surprised to read in their own data that the recovery that began in 1983 had been caused mainly by an expansionary monetary policy. (To a lesser extent, it had come from growth in business investment after changes to corporate taxes in 1981.) Feldstein and Elmendorf pointed out that the recovery had not been caused, as was popularly thought at the time, by reductions in the personal income tax rate.
That is: As early as 1989, Reagan’s economics guy did not find any evidence that the Reagan recovery had come from the Reagan administration’s personal income tax cuts.”
Here’s the abstract of Feldstein and Elmendorf’s paper:
The first two years of the economic expansion that began in 1983 were unusually strong and were accompanied by better inflation performance than would have been expected on the basis of experience in past recoveries. Our evidence contradicts the popular view that the recovery was the result of a consumer boom financed by reductions in the personal income tax. We also find no support for the proposition that the recovery reflected an increase in the supply of labor induced by the reduction in personal marginal tax rates. The driving force behind the recovery of nominal demand was the shift to an expansionary monetary policy. The rapid expansion of nominal GNP can be explained by monetary policy without any reference to changes in fiscal and tax policy. But the growth of real GNP was more rapid than would have been expected on the basis of the rise in total nominal spending and the increase in the price level was correspondingly less. The most likely cause of this favorable division of the nominal GNP increase was the sharp rise in the dollar that occurred at this time. Although part of the dollar’s rise can be attributed to the successful anti-inflationary monetary policy, the dollar also increased because of the rise in real interest rates that resulted from the combination of the increase in anticipated budget deficits and the improved tax incentives for investment in equipment and structures. Thus, expansionary fiscal policy did contribute to the greater-than-expected rise of real GNP in 1983-84 but it did so through an unusual channel. The fiscal expansion raised output because it caused a favorable supply shock to prices and not because it was a traditional stimulus to demand. The budget deficit and investment incentives were expansionary in the short run because, by causing a rise of the dollar, they reduced inflation and thus permitted a faster growth of real GNP.
III. Congressional Research Service Study
After analyzing the relationship between tax rates and economic growth since 1945 the author of the study, Thomas Hungerford, concludes,
“The results of the analysis suggest that changes over the past 65 years in the top marginal tax rate and the top capital gains tax rate do not appear correlated with economic growth. The reduction in the top tax rates appears to be uncorrelated with saving, investment, and productivity growth. The top tax rates appear to have little or no relation to the size of the economic pie.”
IV. Owen Zidar, University of California Economist, Study
I summarized Zadar’s study here, parts of which are copied below.
Contrary to trickle-down predictions, tax cuts for high income earners, identified as those in the top 10%, have a negligible relationship to job creation and is statistically insignificant. Contrary to the mantra that tax cuts for the wealthy “job creators” generates economic growth, Zadar finds GDP growth is associated with tax changes for the bottom 90% of income earners. In Zidar’s own words,
“I find that the negative relationship between tax changes and real GDP growth over a two year period is almost entirely driven by tax changes for the bottom 90%. The empirical relationship between tax cuts for the top 10% percent and job creation is negligible in magnitude, statistically insignificant, and much weaker than that of equivalently sized tax cuts for the bottom 90%.”
The estimated effect of a 1 percent GDP tax cut for the bottom 90% is associated with a 2.7 percentage point growth of GDP growth over a two year period. On the other hand, the same tax cut for the top 10% results in only a 0.13 percentage point gain in GDP growth and is insignicant statistically.
V. Bruce Bartlett, Domestic Policy Adviser to President Ronald Reagan, Examination of the Evidence
On September 2, 2012, I summarized Bartlett’s examination of the evidence, parts of which are copied below.
Bruce Bartlett, domestic policy adviser to President Ronald Reagan and a Treasury official under President George H. W. Bush, took a retrospective examination of the effects of Bush tax cuts on the economy and from the title of his article, “Bush Tax Cuts Had Little Positive Impact on Economy,” you can guess the theme of his analysis.
Here are some key summary statements from Bartlett’s article:
- “A 2006 paper in the American Economic Review by University of Michigan economists Christopher House and Matthew Shapiro found that phasing-in the rate reductions actually reduced growth by causing rich people to put off economic activity into the future.”
- “Subsequent research by Federal Reserve economists has found little, if any, impact on growth from the 2003 tax cut.”
- “It’s hard even to find Republican economists who will defend Bush’s policies. Summing up the Bush years, Douglas Holtz-Eakin, who was chief economist for the Council of Economic Advisers in Bush’s first term, had this to say in an interview with the Washington Post at the end of the Bush administration:
The expansion was a continuation of the way the U.S. has grown for too long, which was a consumer-led expansion that was heavily concentrated in housing. There was very little of the kind of saving and export-led growth that would be more sustainable. For a group that claims it wants to be judged by history, there is no evidence on the economic policy front that that was the view. It was all Band-Aids.”
- “But no one should delude themselves that continuing tax cuts that did nothing for growth over the last 10 years will do anything to stimulate growth in the future.”
VI. Center for American Progress Analysis
On August 20 I posted results of a supply-side economic outcomes from a study by the Center for American Progress, parts of which are copied below.
Over three decades of empirical evidence suggests this theory doesn’t work. The following seven graphs depict the theory’s failure by comparing time periods where supply-side economics prevailed (1980s and 2000s supply-side eras) with a non-supply-side era (1990s).
On June 28, 2012, I summarized a study completed by the Institute on Taxation and Economic Policy, parts of which are copied below.
Conventional wisdom suggests that States without income taxes will experience greater economic growth than States with taxes. This conventional wisdom stems from supply-side, trickle-down economics.
Conventional wisdom and supply-side economics are wrong, according to a study by the nonpartisan Institute on Taxation and Economic Policy.
“Those who don’t believe in Santa Claus or the Easter Bunny anymore, and actually look at facts and data, recognize that since supply-side economics has been implemented in America, the complete opposite of what supply siders had promised has occurred,” said Ralph Martire, executive director at the nonpartisan Center for Tax and Budget Accountability.
VIII. A Closer Examination of Trickle-Down Economics, Focusing on the Economic Outcomes of the Bush Tax Cuts
Historical evidence demonstrates the United States has had some of its strongest periods of economic growth while taxes were high. As the following graph shows, some of our most robust periods of growth in gross domestic product (GDP) actually occurred while taxes were very high:
During the 1950s the USA experienced some of the sharpest periods of economic growth with the top marginal tax rates for the richest Americans above 90 percent! Marginal tax rates were adjusted upward in the 1990s, again with strong economic growth.
If trickle down economic tax cuts worked Bush should have had a great economic record
The Bush tax cuts never trickled down
If trickle down economics worked we should observe growing real median income for the population as a whole. Despite huge tax cuts the desired trickle down outcome did not come to fruition for the majority of Americans, per the following figure.
Median household income grew marginally from 1967 to 2010, despite the massive injection of women into the workforce to sustain a desired quality of life, and huge tax cuts in the 1980s and 2000s. Nor do we see trickle down economics at work from this Congressional Budget Office chart, with more details in a previous post.
The above figure shows the share of market income for every quintile, except the highest quintile, declined 1979 to 2007, as revealed by my arrows added to the CBO graph. If trickle down effects worked as proclaimed then the share of market income should be greater for each quintile in 2007 when compared to 1979, the years prior to the implementation of the Reagan and Bush era tax cuts.
The CBO also produced the data I used to produce the following graph, depicting percent share of pre-tax income by quintile, 1979-2005.
From Economic Policy Institute: The Bush economic expansion had the worst wage and salary growth and total compensation growth of any postwar economic expansion. Workers also fared progressively worse the lower they were in the income distribution.
- Inflation-adjusted median weekly earnings fell by 2.3% during the economic expansion from 2001Q4 to 2007Q4.1 Over this same period, nonfarm business productivity (output per hours worked) increased 15.4%; 2 in essence, wage growth became further decoupled from productivity growth.
- Between 2002 and 2007, real hourly earnings fell 1.7% for men in the bottom 10th percentile of wage earnings, fell 0.4% for men in the 50th wage percentile, and increased 2.4% for men in the 90th wage percentile, continuing a trend of very uneven wage growth.3
- The bottom 90% of earners were left with just 13% of total income gains, significantly less income than the 24% captured by the top 0.01% (those with incomes above $9.5 million).4
- Total employment increased just 0.9% annually—one-third of the average growth in postwar economic expansions—just barely keeping pace with population growth. The 2002-2007 expansion was the only postwar expansion in which the employment-to-population ratio did not rise.5
- The national unemployment rate never once returned to pre-recession levels.6
The Bush tax cuts didn’t pay for itself despite claims it would expand economic growth, thereby collecting more tax revenue
The fallacy that Bush tax cuts would pay for itself through economic growth was exposed by a report issued under the supervision of a supply-side economist handpicked by the White House and published by the CBO. It concluded the president’s budget would make long-term budget deficits worse rather than better.
The Wall Street Journal, at the time an advocate for supply-side economics, and the source of dozens of columns and editorials demanding dynamic scoring to reflect the “true” impact of big tax cuts, examined the results of various CBO models and concluded, “… in every case, the effects are relatively small. And in no case does Mr. Bush’s tax cut come close to paying for itself over the next 10 years.”
Moody’s Analytics Chief Economist Mark Zandi estimates that making the Bush income tax cuts permanent would currently generate only 35 cents in economic activity for every dollar in forgone revenue.7
Unfortunately for the middle class Bush tax cuts and trickle down economic theory didn’t produce strong economic growth, as measured by employment and GDP growth, per the following analysis from the Center on Budget and Policy Priorities:8
If the massive Bush tax cuts worked to create a more prosperous economy President Bush should be regarded as one of the greatest economic growth Presidents in modern times. Just the opposite occurred as explained by the conservative Wall Street Journal.
Bush’s record indicates his administration produced only 375,000 jobs per year in office, just beating Hoover’s record. The Wall Street Journal provides an appropriate summary,
“The current President Bush, once taking account how long he’s been in office, shows the worst track record for job creation since the government began keeping records.”
The Bush tax cuts failed to create strong long-run growth
From Economic Policy Institute: Bush-era tax cuts did not lead to faster economic growth during the economic expansion leading up to the Great Recession.
- Between the end of the 2001 recession (2001Q4) and the peak of that expansion (2007Q4), the U.S. economy experienced the worst economic expansion of the post-war era.9
- Growth in investment, GDP, and employment all posted their worst performance of any post-war expansion.10
- The tax cuts were supposed to encourage business investment, but nonresidential fixed investment increased a meager 2.1% annually—a third of the average increase and less than half that of the next poorest post-war increase in business investment on record.
While the promised jobs and GDP growth failed to come to fruition the cost of the budget-busting 2001 and 2003 tax cuts was, as estimated by Citizens for Tax Justice, roughly $2.5 trillion through 2010.
Ezra Klein provides a more current update:
“The new CBO data show that changes in law enacted since January 2001 increased the deficit by $539 billion in 2005. In the absence of such legislation, the nation would have a surplus this year. Tax cuts account for almost half — 48 percent — of this $539 billion in increased costs. How about the Committee for a Responsible Federal Budget? Their budget calculator shows that the tax cuts will cost $3.28 trillion between 2011 and 2018. This evidence was a tremendous blow to trickle-down/supply side economics.
The Bush tax cuts continue to be expensive
From Economic Policy Institute: As expensive as the Bush tax cuts were in the last 10 years, the cost over the next 10 years will be much, much higher.
- Making the changes permanent would cost about $4.6 trillion over the 2012-21 period.11
- The extension of the Bush tax cuts in the December 2010 tax deal is projected to decrease revenue by $423 billion over 2012-21, pushing the total cost above $5.0 trillion over the next decade.12 This represents about half of the total projected deficits over this period.13
- Just allowing the Bush tax cuts to expire would put public debt on a sustainable trajectory over the next decade, maintaining a constant share of the economy through the entire 10-year period.14
The opportunity cost of the Bush tax cuts is significant. If continued, they will crowd out budget priorities such as economic security programs and investments in education, infrastructure, research, and health.
More evidence against supply side, trickle down economics: The Reagan Era
The Bush era wasn’t the first time supply side economics failed. The usual narrative is that Reagan’s huge tax cuts resulted in extraordinary economic growth. The problem is the facts don’t match the narrative. Here’s a graph by Mike Kimel, reflecting the actual historic facts:
“Yes, there was a tax cut and the economy started growing. But the only growth that was unusually strong for the time period occurred in one single year, from 1983 to 1984. And immediately afterwards it dropped and kept dropping. In 1987, there was a small pickup in growth which accompanied a further tax cut (50% to 38.5%), but the year after, when the top marginal tax rate dropped further (to 28%), growth fell again.
Strip away the rhetoric, and it would seem the “evidence” for the benefits of Reaganomics, for the most part, are that following the small tax cut in 1981 (70% to 69.25%) and the bigger one in 1982 (69.25% to 50%), there was one seemingly extraordinary year of growth from 1983 to 1984.”
Kimel’s analysis of the relationship between real GDP growth and tax rates during 1981-1993 is illuminating, per the following figure.
“It goes without saying that what the graph does not, repeat, does not show is that lower tax rates have much to do with faster economic growth. In fact, some of the slowest sustained economic “growth” that occurred during the Reagan-Bush years coincided with the lowest tax rates: 28% and 31%. The one standout year occurred when tax rates were at 50%, and had been at 50% for a few years. And yet, somehow this period has entered the public consciousness as Exhibit A that Tax Cuts Work.”
After a bit more analysis Kimel adds,
“If you’re wondering, during seven of the 12 Reagan-Bush years, growth rates were actually below the average rate observed when top marginal tax rates were above 90%… and the really slow growth during the Reagan – Bush era occurred disproportionately when tax rates were at the 28% and 31%. That is to say, when tax rates were at their lowest levels in the Reagan – Bush era, growth rates were also at their lowest. And as the graph also shows, every single year, repeat, every single year of the Reagan Bush had a lower average growth rate than when tax rates were in the 60% to 69.9% range.”
There is also the question relating to the effect of Reagan tax cuts on federal revenue. Supply side economics argues in the long term tax cuts will expand the tax base, yielding more federal revenue. As Paul Krugman, a Nobel winning economist, observes after studying Reagan’s application of supply-side economics,
This is exactly what you would expect to see if supply-side economics were just plain wrong: revenues are permanently reduced relative to what they would otherwise have been.
Did wealth trickle down from the rich to the poor as a result of tax cuts designed to produce robust economic growth? The succinct answer is simply no. There’s too much evidence against the theory. Trickle down economics is more of an ideology, utilized to promote an agenda.
1 Bureau of Labor Statistics. Constant (1982-84) dollar adjusted to CPI-U; Median usual weekly earnings, Employed full time, Wage and salary workers.
2 Bureau of Labor Statistics. Major Sector Productivity and Costs Index. Nonfarm business output per hour.
3 State of Working America. 2011. “Wages at the high end are growing faster.” EPI analysis of U.S. Census Bureau, Current Population Survey. http://www.stateofworkingamerica.org/files/files/7%20Wages%20at%20the%20high%20end%20grow%20 faster.xlsx
4 Saez, Emmanuel. 2010. University of California, Berkeley: http://www.econ.berkeley.edu/~saez/TabFig2008.xls. Income cutoffs for percentile distributions have been adjusted from 2008 dollars to April 2011 dollars (CPI-U-RS).
5 Bivens, Josh and John Irons. 2008. “A feeble recovery: the fundamental weakness of the 2001-2007 expansion.” Washington, D.C.: Economic Policy Institute, December 9. http://epi.3cdn.net/ff1869e11dfc0ef295_xxm6b9cj9.pdf
6 Bureau of Labor Statistics. National Unemployment Rate. The national unemployment rate stood at 4.2% in February 2001 and 4.3% in March 2001, when the economy entered a recession.
7 Zandi, Mark. 2011. “At Last, the U.S. Begins a Serious Fiscal Debate.” http://www.economy.com/dismal/article_free.asp?cid=198972&tid=F0851CC1-F571-48DE-A136-B2F622EF6FA4
8 Center on Budget and Policy Priorities. http://www.cbpp.org
9 Bivens, Josh and John Irons. 2008. “A feeble recovery: the fundamental weakness of the 2001-2007 expansion.” Washington, D.C.: Economic Policy Institute, December 9. http://epi.3cdn.net/ff1869e11dfc0ef295_xxm6b9cj9.pdf
11 CBO. 2011. “Budget and Economic Outlook: Fiscal Years 2011 to 2021.” Table 1-7, lines 49 and 50. http://www.cbo.gov/ftpdocs/120xx/doc12039/BudgetTables%5B1%5D.xls. Assumes continuation of the individual income tax and estate and gift tax provisions scheduled to expire on December 31, 2012, excluding the one-year payroll tax cut.
12 Joint Committee on Taxation. 2010. “Estimated Budget Effects of the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” http://www.jct.gov/publications.html?func=startdown&id=3715 This reflects the cost of individual income tax cuts, the AMT patch, and the reinstatement of the estate tax at a $5 million exemption and 35% rate.
13 EPI calculations based on CBO’s “Budget and Economic Outlook: Fiscal Years 2011 to 2021” and “An Analysis of the President’s Budgetary Proposals for Fiscal Year 2012.” Projected current policy deficits are based on CBO’s March 2011 baseline, adjusted for continuation of the 2001 and 2003 tax cuts, the AMT patch, the doc fix (maintaining Medicare physician payment rates), and the overseas contingency operation funding estimates in the president’s 2012 budget request.
14 Horney, James and Kathy Ruffing. 2011. “Economic Downturn and Bush Policies Continue to Drive Large Projected Deficits.” Washington, D.C.: Center on Budget and Policy Priorities, May 10. http://www.cbpp.org/cms/index.cfm?fa=view&id=3490