July 26, 2006
Does tax relief mean more economic growth? Many people believe the answer is yes, and now they get strong support from the staff of the U.S. Treasury, say observers.
Over the past six months, the Treasury Department studied the dynamic effects of tax cuts on the economy. There are three main lessons.
Lower tax rates lead to a more prosperous economy:
- According to the Treasury analysis, a permanent extension of the recent tax cuts would lead to a long-run increase in the capital stock of 2.3 percent, and a long-run increase in gross domestic product of 0.7 percent.
- In today's economy, such a GDP expansion would mean an extra $90 billion a year that the nation could spend on consumer goods to raise living standards, or capital goods to maintain prosperity.
- More than two-thirds of this expansion would occur within 10 years.
Not all taxes are created equal for purposes of promoting growth:
- The Treasury staff reports particularly large bang-for-the-buck from the reductions in dividends and capital-gains taxes.
- Even though these tax cuts account for less than 20 percent of the static revenue loss from permanent tax relief, they produce more than half of the long-run growth.
How tax relief is financed is crucial for its economic impact:
- The Treasury's main analysis assumes that lower tax revenue will over time be accompanied by reduced spending on government consumption.
- But the report also shows what happens if spending cuts are not forthcoming; in this alternative scenario, a permanent extension of recent tax relief is assumed to lead to an eventual increase in income taxes.
- The results are strikingly different -- instead of increasing by 0.7 percent in the long run, GDP would fall by 0.9 percent.
Source: Robert Carroll and N. Gregory Mankiw, "Dynamic Analysis," Wall Street Journal, July 26, 2006; based upon: "A Dynamic analysis of Permanent Extension of the President's Tax Relief," Office of Tax Analysis U.S. Department of the Treasury, July 25, 2006.
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