Thursday, September 16, 2010

Taxes and Revenue, the Chris Dudley Proposal

Chris Dudley, Republican candidate for Governor, presented his 20-point plan for promoting employment and the Oregon economy. [Funny how these things always miraculously come out to nice round numbers - why not a 19 or 23 point plan?]  Anyway, the key points appear to be decreasing taxes and in particular capital gains taxes, (many of the other points are bromides rather then specific proposals).  This makes sense politically, after the passage of Measures 66 & 67 taxes are an obvious focal point for Republicans.  But do they make sense economically?  Perhaps.

When I first heard the news reports on the plan the sound bite they chose to play was of Dudley trying to make the point that the tax cuts would likely pay for themselves in terms of extra revenue.  To me this sounded like the tired Laffer curve argument that has been discredited for marginal income tax rates as low as we have in the US.

As an aside, if you are wondering about income tax rates and the disincentive to work, most economic studies put the tax rate at the peak of the revenue curve (i.e. after which revenues actually decline when you increase the rate) at over 70%.  Here is perhaps the foremost expert on the matter, Emmanuel Saez of UC Berkeley, quoted in the Washington Post:

The tax rate t maximizing revenue is: t=1/(1+a*e) where a is the Pareto parameter of the income distribution (= 1.5 in the U.S. and easy to measure), and e the elasticity of reported income with respect to 1-t which captures supply side effects. The most reasonable estimates for e vary from 0.12 to 0.40 (see conclusion page 47) so e=.25 seems like a reasonable estimate. Then t=1/(1+1.5*0.25)=73% which means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed

And here is a passage from Greg Mankiw's textbook:

Laffer's argument may be more compelling when considering countries with much higher tax rates than the United States. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work.
But you should note that Saez's analysis is a static one, not considering the long-term growth effects of tax cuts.  Perhaps by promoting growth in the long-run, over time cutting taxes will promote growth.

Capital gains taxes are more nuanced than the tax rate on labor income since capital gains taxes are on often associated with the very investments that we think are good for economic growth, especially in productive capacity.   We want to encourage investments in new businesses and in revenue enhancing productive capacity, and one way to do so is to increase the reward on such investments - by lowering the tax rates.  There are also many other types of investments that fall into this category that are not so obviously growth enhancing like buying and selling stock.  If the share price goes up, the investor makes a capital gain, but this gain does not necessarily represent an investment in productive capacity.

So what is the answer, will this pay for itself?  The first part is pretty clear: in the short-run we should expect tax revenues to decrease.  The second part, the question of whether the cuts will this enhance growth in the state enough over time so as to raise tax revenues to a level higher than they would have been without them, is not clear.  And no good answer exists to this question.

Here is the conclusion form a CBO report on capital gains taxes and growth:

Revenue estimators are often faulted for the way they project tax receipts and prepare legislative cost estimates related to capital gains taxes. But the relationship of realizations and receipts to gains tax rates is neither predictable nor obvious. And while reductions in the overall taxation of capital income can measurably increase economic growth, a cut in capital gains taxes alone is likely to produce much smaller macroeconomic effects. Inaccuracies in projecting revenue and disagreements about the effects of tax changes stem not from a failure to incorporate the behavioral responses of asset holders but from the complexities inherent in the nature of gains and gains realizations.

So in the end, we don't really know, especially in the case of a state as opposed to a country. I think one could target specific investments in new business, new capital, etc. and exclude things like earnings from stock sales and have a smaller short-term revenue impact while getting the growth boost you are hoping for.

And this is getting too long, but my first impression is that the tax credit for businesses who hire unemployed workers is a very good proposal as a temporary measure.


NB: I was trying to decide what kind of picture to use of Dudley and it made me wonder if the Dudley campaign likes the use of Dudley-as-Blazer pics as they create the positive association with the Blazers (in most Oregonians minds, I would think this is positive), or do they want to get away from the basketball player identity and try and make him seem wonkish by showing him in button up shirts and a serious expression. To me, the picture I showed rocks, baby: get that rebound big man!


Jeff Alworth said...

Help a poor non-economist out. If we look at periods in American history when marginal tax rates were very high versus very low, there doesn't seem to be much correlation with broader economic health. During the great post-war expansion, top marginal rates were well above Laffer's point.

Don't the models have to reconcile with actual historical examples, or is this just fuzzy thinking?

GeoGeek said...

When I heard the reports on OPB this morning, I just groaned: "Not this Laffer Curve nonsense again." (Which probably tells you what I think of it..)

Patrick Emerson said...

The causality between taxes and growth is so hard to uncover that the empirical question is still very much open. Obviously fast growing countries don't need to tax as much because growth both brings in wealth and social service demands are lower - and vice-versa. So untangling the causality is a mugs game. It is true that there is definitely no smoking gun out there, no clear depiction of how capital gains taxes depress growth.

Most studies of the tax-growth connection are theoretical and therefore subject to assumptions. And yes, these models are calibrated with historical data (they have to be able to reproduce what we have experienced). Nevertheless, they are still very much subject to assumptions. But the extremes are pretty uncontroversial - there has to be a point at which taxes on productive capacity investments actually constrains such investments so much that growth suffers. Where that point is is guesswork.

How much this matters on a state-by-state basis is another open question. My suspicion is that this is not a terribly important aspect as compared to, say, investments in education and R&D (which Dudley's plan also includes, by the way).

jaypee said...

Look at that free throw percentage.... that is the kind of stuff nightmares are made of. Really, if Chris Dudley can't shoot 50% from the line, can we AFFORD to vote for him?