Mr. Chairman, Senator Baucus, and Members of the committee:
Thank you for inviting me to testify today. It is an honor to appear before this committee. President Bush and members of Congress have proposed several new tax-based incentives aimed to raise economic growth. My testimony is divided into two sections: a summary of the conclusions, and supporting analysis.
Summary of major conclusions
The first two conclusions focus on how to frame and consider policy questions relating to taxes and economic growth. The next four conclusions relate to specific policy options.
—In considering policies to spur the economy, it is important to distinguish short-term and long-term problems.
In the short-term, the major economic problem is inadequate aggregate demand, as evidenced in particular by low rates of utilization of capital among businesses. The key to boosting the economy in the short-run is boosting demand in order to fully utilize existing capacity.
In the long-term, the economic growth depends on the extent to which productive capacity (including physical capital, human capital, and economic institutions) is able to grow. Sustained increases in such capacity require increases in national saving.
—Tax cuts have ambiguous effects on economic growth in the long run.
Tax cuts can affect economic growth in the long run through at least two channels. First, a tax cut will affect labor supply, human capital accumulation, saving, investment, entreprenuership and so on. Second, the reduction in revenues will raise the federal deficit (unless matched by spending reductions) and hence reduce national saving.
The net effect on growth is the sum of the (generally positive) effects created by more favorable economic incentives and the (negative) effects created by the increase in the deficit. For the tax cut to have a net positive effect on growth, the effects on labor supply, saving, etc., not only must be positive, they must be larger than the drag created by the increased deficit.
Increased deficits reduce national saving and future national income regardless of whether deficits raise interest rates. One of the best ways to encourage economic growth is to keep national saving high, which in turn implies that public saving should be high.