The Bush Tax Cuts Worked.

The ”Bush tax cuts on the rich” are generally viewed as a “failure”. If the criterion is that the tax cuts would have saved the economy from financial meltdown, that is certainly true. Of course it is absurd to think that cutting taxes by 3-5 percentage points would prevent a gigantic financial meltdown.

Another question is if the tax cuts were entirely self-financing, so that cutting taxes would completely pay for itself. This did not happen, nor should we have expected it to given what we know about short-medium run responsiveness of the tax base to tax rates.

However, this requirement is also too extreme. I think the important question is if tax cuts stimulate growth by a reasonable amount. For tax cuts to be completely self-financing, they have to stimulate growth enourmosly. This only happens either if the responsiveness to taxes is very high (in fact it seems to be moderately high) or if tax rates are extremly high (which they are not in the US.). But what if tax cuts in the American setting stimulates growth by a good deal, but not enough to be self-financing? Should we throw away a useful tool just because it is not Voodoo?

The detractors of the tax cuts seem to be going to the other extreme, arguing that the Bush tax cuts had no effect at all on growth, and that they were not at all self-financing, and therefore that supply-side economics is totally wrong.

But remember that actual supply side economics claims that tax cuts stimulate growth. It is only vulgar or straw-man supply side economics that claim that tax cuts always stimulate growth by the extreme amounts required for tax cuts to be 100% (or more) self financing.

Here research comes in. Economists have in fact studied the effects of the “Bush tax cuts for the rich” on the tax base. The answer is that they did stimulate the economy, and were partially self-financing, about 40% self-financing to be exact. That is a pretty good deal: for each $0.6 dollars that the government loses in revenue the private sector gains $1 dollars.

The paper “The 2001 and 2003 Tax Rate Reductions: An Overview and Estimate of the Taxable Income Response” By Gerald Auten, Robert Carroll and Geoffrey Gee in the National Tax journal in 2008 calculates the responsiveness of income on tax rates, and finds that also in this case did people whose tax rates go down increase their taxable income (their standard estimate of the elasticity of taxable income if 0.4 in this period, in line with the literature). Regarding the tax cuts for the rich, they find that:

“Overall, the increase in taxable income translates into higher revenues that offset about 39 percent of the static revenue loss associated with the reduction in the top two tax rates.”

Empirical evidence suggests that Supply side economics worked as predicted in theory, also regarding the Bush tax cuts.