Her resume appears at the end of the piece, for those who know, she requires no introduction.
By CHRISTINA D. ROMER
Published: March 17, 2012
AT least since Calvin Coolidge, politicians have trumpeted the supply-side benefits of cutting marginal income tax rates. Lower rates will unleash economic growth and the cuts will largely pay for themselves — or so it’s often said. Yet careful studies find little evidence of such effects. Perhaps it’s time to reform tax policy based on facts, not worn-out assumptions.
Here we have the perfect example of the scientific methodology of the physical sciences, trying to be applied to the social sciences, of which economics, or rather econometrics is the scientised version. This empirical methodology is incorrect.
A family’s marginal tax rate is what its members pay to the government if they earn another dollar. If the government takes a smaller chunk of that dollar, a family has more incentive to earn it. Workers may choose to work additional hours, or a stay-at-home spouse may decide to work outside the home. Likewise, entrepreneurs may invest in a new enterprise or expand an existing one. Lower marginal rates also reduce people’s incentives to shield income from taxes, through legal and illegal means.
The marginal tax rate is correctly defined. Assumptions on the actions of individuals are just that, assumptions, as likely to be right as wrong. As such, the empirical method is immediately doomed to failure: one set of individuals may do “X” the next set “Y”, with the first set switching to “Y” next time round. Wrong methodology.
The main question is whether these incentive effects are large. If they are, cutting marginal rates could cause a sustained surge of hard work and entrepreneurial activity — and thus reported income. This idea was the essence of President Ronald Reagan’s theory of supply-side economics, and his justification for large, permanent tax cuts in the early 1980s. Mitt Romney, now seeking the Republican nomination for president, cited a similar argument when he proposed cutting all income tax rates 20 percent.
The answer lies in ‘diminishing marginal utility’ and ‘time preference’. All individuals will allocate their money into cash balances, consumption spending and saving/investment. These ratio’s may fluctuate, in fact, you can say that they will fluctuate, depending upon changed and changing circumstances.
What then, what set of conditions, would increase the saving/investment proportion relative to cash balance holdings? [i] An increase in the purchasing power of money. If money held, increased it’s purchasing power, less of a reserve would need to be held to accomplish the same ends. The spare, or surplus, could now either be saved/invested, or consumed.
Even if the decision was to consume, viz. higher time preferences, diminishing marginal utility’ would limit this consumption spending in all but the poorest, who essentially have to spend all income just on necessities to survive.
For the rest, surplus money, would now be saved/invested, a lowering of time preferences, which would do three things: [i] lower the market rate of interest through lowering the natural rate of interest [ii] thus promoting longer, more roundabout production methods [iii] which increase supply, thus lowering nominal and real prices [iv] which again increases the purchasing power of money, thus reinforcing the virtuous cycle.
If the incentive effects are small, however, the situation is very different. Cutting taxes would still raise output for a while by putting more money in people’s pockets, and so increasing their spending — a temporary demand-side effect. But lower marginal rates wouldn’t greatly raise output over the long haul through the supply side.
Romer has considered only a single possibility, and just assumed this case will hold. That is simply incorrect.
History shows that marginal federal income tax rates have varied widely.
An empirical time series data. A historical fact pertaining to the individuals and circumstances that pertained uniquely to them. Empirical data have no predictive power, much as the econometric’s wish that they did.
Since World War II, the top rate has ranged from less than 30 percent (at the end of the Reagan presidency) to more than 90 percent (throughout the Eisenhower years). The 1964 Kennedy-Johnson tax cut significantly reduced the typical marginal rate paid by American families, but rates rose greatly over the next 15 years as inflation pushed people into higher tax brackets. Rates fell sharply under President Reagan, rose under President Bill Clinton and fell again under President George W. Bush.
And who created that inflation? Why government. Inflation, after all, is nothing more than a tax that is hidden as much as possible from view. Pure theft.
If you can find a consistent relationship between these fluctuations and sustained economic performance, you’re more creative than I am. Growth was indeed slower in the 1970s than in the ’60s, and tax rates were higher in the ’70s. But growth was stronger in the 1990s than in the 2000s, despite noticeably higher rates in the ’90s.
First, what taxes are we referring to? Corporate tax or individual tax? What drives growth? Savings, which are investment. The nineties saw unprecedented investment in the US stockmarkets through individuals. Investment in common stocks is investment, which drives more roundabout production and increased supply. The investment was driven by a paradigm of technology creating a new era. Let’s look at further data.
It can be seen that the trend in ‘income tax’ the tax that us poor slobs have to pay, was trending lower. Yes the tax was higher in the 2000’s, but it was lower than 70’s & 80’s. In addition capital gains taxes were falling, driving investment in risk assets. The whole story spun by Romer, is designed to mislead.
The government, has systematically shifted the tax burden, not only in marginal rate terms, from the corporation to the individual, who it must be said, has far less opportunity to shield his tax obligation than does the corporation.
Of course, many factors affect the economy, so a lack of correlation doesn’t prove that marginal-rate changes have little impact. That’s why economists have devoted thousands of pages in journals to testing the effects more scientifically.
Of course, and they are called individuals. On aggregate, time preferences drive the consumption, hoarding & saving/investment decisions. The higher the tax rate, the higher time preferences have to go, as you remove money from individuals thus forcing an adjustment in their diminishing marginal utilities.
ONE standard approach is to look for natural experiments in the tax code. Often, a law changes the marginal rate for one group and not others. For example, the 2001 Bush tax cut lowered marginal rates sharply for married couples with taxable incomes of around $50,000, but did little to rates for couples earning slightly less. Using household survey data, economists can compare the behavior of taxpayers whose rates did and didn’t change.
Change the groups via a different time period and conditions and you can alter the result. Econometrics is simply untenable as economics.
A useful summary measure of such changes’ supply-side effects is the sensitivity of reported income to marginal rates. If people work and invest more in response to tax cuts, their reported income will rise when marginal rates fall.
If their marginal tax rate falls, they will earn the same, just keep more of it. After that it is all conjecture. Some might, some might not. What is important are individual allocations proportionally, to their time preferences.
True supply-siders believe that this sensitivity is well over a value of 1, implying that cuts in marginal rates raise reported income enough that government tax revenues nevertheless rise. But a critical review of several natural-experiment studies concluded that the best available estimates of this sensitivity range from 0.12 to 0.40. The midpoint of the range, 0.25, implies that if the marginal tax rate for high earners decreased from its current level of 35 percent to 28 percent (which Mr. Romney proposes), reported income would rise by just 2 1/2 percent.
Again, change the group, change the circumstances, and you potentially change the result. One simple example should suffice: the expectations of the individuals, and thus their planning of desired ends – can totally change the results.
The fact still remains: increase taxes, you increase time preferences. You have to, there is no alternative as you alter the diminishing marginal utility of money. Only those who retain surplus income past consumption and cash balances can allocate to saving/investment. The higher the marginal rate, the smaller that group.
In a new study, David Romer and I found that changes in marginal rates in the 1920s and ’30s had even smaller effects. (Mr. Romer is my husband and a colleague at Berkeley.)
Different time period, different individuals. I like the appeal to authority, viz. we work at Berkley, therefore we must be smart. Not half as smart as you think old girl.
The rate shifts in that era make those after World War II look tame, and varied greatly across income groups. The Revenue Act of 1935, for example, raised marginal rates on the very highest earners to 79 percent from 63 percent, but barely raised rates at all for those below the top one-fiftieth of one percent of households. (Now that was class warfare!)
That may well be true, but look at the increase in the tax base of individuals now required to file a tax return.
We found that an increase in marginal rates on an income group leads to a decrease in its reported taxable income relative to other groups. Indeed, because the variation is so large, the effect can be pinned down much more precisely than in most postwar studies. But the estimated impact is very small — almost at the bottom of the postwar studies’ range. One likely reason is that the tax system between the two world wars was very simple — all the instructions and tax forms for the personal income tax fit on just six pages. As a result, there were few legal methods of shielding income.
She raises two points here as a result of her studies: [i] that an increase in marginal rates on an income group reduces taxable income [ii] the estimated impact is small. Then a reason, simple tax code legislation. The entire paragraph says what?
Where does this leave us? I can’t say marginal rates don’t matter at all.
Of course not. They do. They alter time preferences for individuals.
They have some impact on reported income, and it’s possible they have other effects through subtle channels not captured in the studies I’ve described.
Indeed they do. You can’t measure them at all. All that you can observe is the historical outcome that the time preferences of individuals resulted in. They are predictive in stating that, the higher the tax rate, the higher the time preference has to be. This will result in lower proportionally, savings/investment. Lower investment results in lower production and lower supply, which means that prices will remain higher than they otherwise would.
But the strong conclusion from available evidence is that their effects are small. This means policy makers should spend a lot less time worrying about the incentive effects of marginal rates and a lot more worrying about other tax issues.
Most obviously, the federal budget is on a collision course with reality. Reining in the long-run deficit will have to involve slowing the growth rate of spending. But unless we choose to gut Medicare and Medicaid, additional tax revenue will be needed. This essential truth is the No. 1 factor that should be driving tax policy. And anyone who tells you that the way to raise revenue is to cut marginal tax rates is arguing from ideology, not solid evidence.
Government revenue. But really, who cares about government revenue. Government needs to cut spending, not concern themselves with raising additional tax revenue. I note she mentions the two scary, and with a political demographic in mind, Medicare & Medicaid, add to that Social Security, and you have the so called third rail of American politics.
Many people have proposed raising revenue by cutting back on deductions and loopholes — so-called tax expenditures. Indeed, all else being equal, such changes are preferable to raising marginal rates. After all, higher rates do have some disincentive effects. Eliminating special tax provisions would also simplify tax preparation, and give people less incentive to try to game the system.
Higher rates lower production. That is bad. End of story.
But if moderate increases in marginal rates wouldn’t much affect behavior, a mix of rate increases and cuts in tax expenditures might be a sensible path.
Increases in tax always effect a change in time preferences higher. Fact. Cutting government spending is the only viable way forward.
Some tax expenditures, like the favorable tax treatment of employer-provided health insurance, may have worrisome effects (by encouraging overly generous plans) and so should be trimmed. But others, like deductibility of charitable giving, may be worth keeping.
All rules that prevent, or shield income from tax must be kept, although the two mentioned still result in less income to the producer. The government has still forced a redistribution.
Finally, income inequality has surged in recent decades.
Yes it has. There is a good way and a bad way. If I as a producer supply a product or service that individuals demand, I provide a service, and am rewarded for my foresight. In this, if my income rises, that is for the good.
When you income rises due to incompetence, dishonesty, bailouts at the expense of the taxpayer, well that is something else entirely. That is why the banks are so universally despised currently. It would be hard to find another group of individuals who are as corrupt, greedy and plain fucking stupid, than the bankers.
Raising marginal rates on the wealthy is a straightforward, effective way to counter this trend, while helping to solve our looming deficit problem.
Incorrect. All you succeed in doing is altering the final group’s time preferences from saving/investment to horading and consumption. Rather, you lower taxes to expand the saving/investment choice to a larger base of individuals.
Given the strong evidence that the incentive effects of marginal rates are small, opponents of such a move will need a new argument. Invoking the myth of terrible supply-side consequences just won’t cut it.
Your evidence, proves nothing.
Christina D. Romer is an economics professor at the University of California, Berkeley, and was the chairwoman of President Obama’s Council of Economic Advisers.
Which is what makes this so scary. That such an incompetent fool was responsible for driving policy, truly, is terrifying. That she may, or may not still have political influence, well, let’s hope not.