Will tax hikes hurt economic growth?

COMMENTARY The Congressional Budget Office's latest Budget and Economic Outlook showing the magnitude of the long-run deficit problem we face is another reminder that it can't be solved by program cuts alone. The cuts required would be too deep to be acceptable. An increase in revenue is what's needed.

If that's true, why are politicians, particularly those on the right, taking such a strong stance against tax increases of any kind? Taking a hard line on tax increases and insisting on program cuts is an attempt to make as much of the adjustment as possible accord with their ideological preference for smaller government. But politicians understand that enhanced revenue will be part of the final package, even if their political posturing suggests otherwise.

But there is another reason for this posturing against tax increases beyond the hope for a smaller government. The resistance to tax increases from some some quarters is over who will end up paying the increased revenue. Will it be tax increases for the wealthy, closing deductions such as the one for mortgage interest, tax increases for the middle class? Who, exactly, will foot the bill?

This is evident in the testimony of CBO Director Doug Elmendorf before Congress, explaining the budget office's findings. As Megan McArdle of The Atlantic writes:

It's no surprise that Doug Elmendorf's appearance before Congress...was dominated by political grandstanding, as members asked extremely loaded questions designed to get Doug Elmendorf to say that we should close the hole by either raising taxes or cutting spending.  Elmendorf ably ducked these attempts to lead him, but you could see him steeling himself every time a new congressman took their turn.

As this issue heats up, you will hear again and again that tax increases, particularly on the wealthy, will depress economic growth. However, as I detailed in a previous article, there's very little evidence that tax changes of the magnitudes and types being considered will have a significant impact on economic activity:

Economic theory helps us to determine which types of taxes are best in terms of efficiency, but the equity of taxes -- who pays them and whether it's fair -- also matters. Questions of equity must be resolved in the political arena, economics cannot help here, and equity is one of the factors that determines whether a tax is feasible. If allowing the Bush tax cuts to expire for the wealthy is the only acceptably equitable way to raise taxes in this political environment, then there is little evidence that this will be harmful. The cost of allowing these tax cuts to expire is low, and there is much to be gained in terms of reducing our long-term budget problem.

There are ways to produce negative effects from tax increases, and there are ways to harm growth through program cuts as well. I don't mean to imply otherwise. But despite the concerted attempts to make people think their jobs are on the line if certain types of tax increases, e.g., for the wealthy, are put into place, given the plans on the table this is fundamentally a political issue about the size of government and how to pay for it equitably rather than an issue about avoiding economic harm. In fact, if avoiding harm to individual households in one form or another is an important objective alongside deficit reduction, as I think it should be, we should worry just as much about program cuts as tax increases.

[Milton Recht]

As often happens in discussions about tax increases, the debates ambiguously interchange tax rate with tax revenue increases. If the issue is reducing the deficit, then along with spending reductions, tax revenue increases must occur. Tax rate changes, up or down, without a tax revenue increase will not produce more government funds. Since avoidance of government program or subsidy cuts are often mentioned side by side with tax rate increases, there are also issues of consumer welfare and how tax policy affects the nation's, or sub-population group's, well-being.

If effective tax rates are increased, taxpayers will undertake mitigating tax effects to reduce their taxes, e.g. buy more municipal bonds, delay sales producing capital gains, work less, delay investment, switch to more tax favorable investment categories, etc.

The economy and individuals will react to tax law changes and the amount of revenue from tax law changes has a degree of uncertainty. Behavior will change. The uncertainty is whether the behavioral change will offset the tax increase completely or only partially. Depending on the tax change and individual economic behavior, total revenue may go up, go up by less than projected, decline or remain the same.

Add to the debate that governments often spend increased tax revenue on programs, benefits and subsidies, which have their own negative and positive economic effects on employment, economic growth and future tax revenues. Additionally, consumer welfare changes are usually not modeled as part of tax law changes.

CBO uses JCT (joint committee on taxation) numbers for the amount of expected tax revenue from a proposed tax law change. Unfortunately, JCT models for tax law changes, while they assume some tax reducing behavioral responses, assume that taxes do not affect the overall growth of the US economy. JCT assumes away any economic growth affects from tax changes. In other words, Congress takes a blind eye that its tax law changes may affect the economy.

If the economy grows, there will be more tax revenue even if there is no change to tax rates, i.e. rates are not increased or lowered.

If tax rates are increased, individual and government behavior will change that will affect the economy. The economy could grow, grow less than if there were no tax changes, or decline. Tax revenue may increase, remain static or decline depending on the amount of economic and behavioral affects and the amount of change in tax rates.

The issue of tax law changes is more important now than it has been in a long time. US economic output is well below its long-term trend. The gap between the potential US economy and the current economy is enormous, as measured by total GDP, GDP per capita, workforce participation rates, and employment levels.

While the US current and projected deficit is a concern, so is the US economic output gap. Policies that can foster faster economic growth, increase employment and workforce participation must be part of any policies that bring the projected US deficit to manageable levels.

Additionally, there is the unstated the assumption that if tax reduction, or tax policy inaction, occurs, general welfare will decline due to program cuts. While program cuts and benefit decreases may occur, it is a gigantic, illogical leap to assume that overall, or in any specific US population subgroup, general welfare will decline. Government legislated program mandates are often paternalistic with restrictions on eligibility and benefit use. They substitute government choices for individual participants' free choice. Program eligibility requirements have implicit high marginal tax rates, at the point where the benefit is lost. Along with benefit use restriction requirements, there is no certainty that a program participant's welfare is better with a government program that without.

[JerryNA100]

Milton,
You used a bunch of big words to say "don't raise my taxes, cutting gov't programs won't hurt the little guy making less than me". (I have a Ph.D., so I'm not afraid of big words, just exasperated that you used so many words to say so little.) What you glaringly failed to do is provide a citation. There have been a lot of analyses showing that government programs under Democrats (i.e. pro-social programs) raise the economy more and for everyone, rather than the Republican "cut taxes" mantra that benefits the few (and not even as well).
See
http://www.eriposte.com/economy/other/demovsrep.htm
and
http://survivalandprosperity.com/2011/04/13/democrats-or-republicans-better-for-economy/
and
http://www.investopedia.com/articles/financial-theory/08/political-party-democrat-republican-stock-returns.asp#axzz1YRZYQfRD
Show your numbers, or just be honest and admit my translation is correct.