Cutting Taxes Could Also Cut Growth

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

June 23, 1996

Ronald Reagan’s 1981 across-the-board tax cuts were followed by seven years of robust economic growth. From 1982 to 1989, output rose by 3.9% a year, even after adjusting for inflation. Since 1989, growth has been more sluggish, averaging 2% a year. As the election campaign heats up, there are increased calls for tax cuts to stimulate the economy and reenact the 1980s growth experience.

If only it were that easy.

The unfortunate truth is that tax cuts now would not lead to any serious increase in economic growth and could cause a reduction in growth by raising the deficit.

The standard story is that reducing taxes will raise saving, investment and productivity, which would in turn lead to higher growth. However, despite steep cuts in marginal tax rates in 1981, the advent of IRAs and high real interest rates, the simple fact is that business and household saving did not rise in the 1980s and the national (public plus private) savings rate fell as budget deficits rose. Private investment did rise for a few years, with the increase in investment being funded by an inflow of foreign capital. But by the mid-1980s, net investment had receded to its earlier levels. In light of these facts, it should not be surprising that productivity growth trends did not rise during the 1980s either.

If increased saving did not cause the robust growth from 1982 to 1989, what did? One factor was the ordinary operation of the business cycle; 1982 marked a sharp recession, which had just followed an earlier recession. The unemployment rate dropped dramatically from 1982 to 1989. Business utilization of existing capacity rose strongly, to about the peak level it had achieved in the previous business cycle.

A second factor was the dramatic buildup of government debt, which fueled demand, and was due in large part to the 1981 tax cuts. A third factor was a massive inflow of foreign capital, noted above, which financed a temporary increase in investment.

Lastly, there was a historic increase in the labor force, in part because of lower tax rates but also because of the changing role of women.

The key point is that the sources of growth in the 1980s are either not currently available or may represent poor policy choices today. Capacity utilization and unemployment are already at or close to their 1989 levels. Further improvement in these figures seems unlikely and would be small in any case. The ratio of debt to gross domestic product has deteriorated further since 1989. Additional large-scale budget deficits would be likely to meet stiff resistance in bond markets and would thwart attempts to raise growth.

The bottom line is that further growth will have to come the hard way: via increased national saving or increased work effort. How much can we expect?

Suppose the current tax rate on capital income is about 30%. This may seem low, since the top rate on households is 39.6% and corporations pay 35%. But after factoring in the deductibility of corporate interest payments, the light taxation of housing, the ability to defer capital gains and the massive role played by tax-preferred saving vehicles such as pensions and 401(k)s, 30% may actually be an overestimate.

A 15% across-the-board tax cut would reduce the effective tax rate by 4.5 percentage points, so it would raise the after-tax return by less than 7% (from 70 cents to 74.5 cents on the dollar). Applying a relatively high saving response, based on estimates by Stanford economist Michael J. Boskin, suggests that private saving would rise by 3%, from about 5% of GDP to about 5.15%. This $10-billion increase in saving would have virtually no effect on growth in a $7.3-trillion economy. Similar calculations suggest that we may also get a limited boost—about a 1% increase—from increased work effort.

With an anemic economic response, the deficit could rise by $50 billion or more. If the deficit rose by more than private saving rose, national saving would fall, which would adversely affect growth.

Across-the-board cuts in tax rates would generate little in the way of growth but could be budget busters. It would make more sense to consider ways of restructuring the existing system, keeping revenues constant, than undercutting the revenue base of the government.