An unexpected increase in revenues, as documented by both the Administration in its Mid-Session Review and the Congressional Budget Office (CBO) in its August update has led to a renewed discussion of the effect of the 2001-2004 tax cuts on the economy and the possible feedback effects on revenue. Some proponents of the tax cuts suggest that induced economic growth was large enough that taxes on the additional income more than offset the cost of the tax cuts, causing an increase rather than a decrease in revenues. Other observers doubt that economic growth was related to the tax cuts, or that it was large enough to significantly offset the cost of the cuts. After reviewing the data on the revenue increase, this report examines available economic studies, theory, and empirical data to assess the possible revenue feedback from the 2001-2004 tax cuts. They can be separated into three types of effects: demand-side stimulus effects including the eventual consequences of increased debt, "supply-side" effects on labor and capital, and changes in the allocation of consumption and other forms of taxpayer avoidance. As time goes on, assuming revenues are not fully recovered and as the stimulus fades, the effect of the tax cuts is to reduce output by reducing the capital stock from what it otherwise would have been, magnifying the deficit through growing interest payments and also reducing tax revenue from what it otherwise would have been by reducing output. CBO reports that debt service would add 25% to the cost of an across-the-board tax cut over 10 years. They do not likely explain the increase in revenues projected for FY2006 as they amount to no more than 2/10 of a percent of GDP even at the peak, and the effect should be declining. Should a Feedback Effect be Attributed to Tax Policy? Some of these latter effects are, however, already incorporated in conventional revenue estimates by the JCT. Note that theoretically, one cannot be sure whether this effect is positive or negative, because of income and substitution effects. A tax cut's marginal effects may increase taxable income through increased labor supply or shifting into taxable forms, but the income effect may reduce labor supply or increase charitable contributions. The permanent revenue feedback effect for the 2001-2004 tax cuts is also likely to be relatively small, no more than 10%, and the magnitude is not entirely clear. In the case of effects on the deficit, these offsetting effects probably occur within the first few years, and thereafter, the accumulation of debt and interest payments adds increasingly to the deficit beyond the conventional revenue costs. The studies and information presented in this report suggest that, at this time, there is not convincing evidence that the positive revenue feedback from the 2001-2004 tax cuts have been of sufficient scale to fully offset their cost to the Treasury.
An unexpected increase in revenues has led to a renewed discussion of the effect of the 2001-2004 tax cuts on the economy and the possible feedback effects on revenue. Some proponents of the tax cuts suggest that induced economic growth was large enough that taxes on the additional income more than offset the cost of the tax cuts, causing an increase rather than a decrease in revenues. Other observers doubt that economic growth was related to the tax cuts, or that it was large enough to significantly offset the cost of the cuts.
This report reviews available economic studies, theory, and empirical data to assess the possible revenue feedback from the 2001-2004 tax cuts at this time. Four sources of feedback are examined: short-run demand-side stimulus effects, supply-side effects on labor supply and savings, shifting of income from non-taxable to taxable form, and debt service effects.
Of the potential sources of feedback, none appears very large relative to the direct revenue cost, and offsetting effects suggest that the effects of the tax cut on the deficit will be to magnify the direct cost rather than reduce it. One source of effect is the short-run stimulus; this effect is temporary, and appears likely to be small, resulting at the peak (about a year and a half following adoption) of no more than a 14% feedback. At the same time, the effect of the deficit in crowding out private capital reduces tax revenues. The debt also adds to the deficit directly through debt service, which can increase the cost of a tax by as much as 25% over the first 10 years, and by larger amounts as time goes on.
Conventional supply-side effects arising from increased work and savings are unlikely to have feedbacks of over 10%, and there is some reason to believe that the short-run feedback effect is no more than 3%. There are also some potential feedback effects from shifting into taxable income forms and reducing avoidance, but adding these effects to the conventional supply-side effects still produces a feedback effect in the neighborhood of 10%. Moreover, some of these effects are already incorporated into conventional revenue estimates and they may be overstated for other reasons.
Given the positive and negative effects, it is likely that the feedback effect in the very short run would be positive, but at the current time as the stimulus effects have faded and the effect of added debt service has grown, the 2001-2004 tax cuts are probably costing more than their estimated revenue cost.
This report will not be updated.