One of the most frequent arguments for extending the tax cuts and for making them permanent is that failing to do so would hurt economic growth. Is this true? One way to answer the question is to ask whether the Bush tax cuts had a large impact on growth after they were enacted.
What impact did the Bush tax cuts have on economic growth?
The evidence is not favorable. For example, according to this Census report (see table A1), median household income in 2007, adjusted for inflation, was lower than it was in 2000. And as the non-partisan Center on Budget and Policy Priorities reports, based upon data from the Bureau of Labor Statistics, employment growth was particularly weak, "with employment and wage and salary growth ... lower than in any previous post-World War II expansion. Employment grew at an average annual rate of only 0.9 percent from November 2001 to September 2007, as compared with an average of 2.5 percent for the comparable periods of other post-World War II expansions. In addition, real wages and salaries grew at a 1.8 percent average annual rate in the 2001-2007 expansion, as compared with a 3.8 percent average annual rate for the comparable periods of other post-World War II expansions."
Thus, there is little evidence to support that the Bush tax cuts had a significant effect on growth. In addition, contrary to the argument that the tax cuts would pay for themselves being made at the time the tax cuts were enacted, the deficit ballooned as a result of the tax cuts.
Why didn't the tax cuts have a stronger impact on growth?
For one, most of the tax cuts Bush initiated in 2001 weren't of the type that would be expected to have a large impact on growth. As noted by former Reagan economic advisor Bruce Bartlett, "the Bush plan was a hodge-podge of tax gimmicks designed more to win the support of various voting blocs than stimulate growth." After listing the various elements of the tax proposals he then concludes that "The only supply-side element was a modest reduction in the top statutory income tax rate from 39.6 percent to 33 percent -- higher than it had been during Bush's father's administration -- that would be phased-in over a number of years."
However, the second round of tax cuts under Bush in 2003 was a bit more faithful to the supply-side cause. The second round involved a reduction in the tax rate on both capital gains and dividends to 15 percent, with the dividend cut being particularly large. But even so, as the statistics above on income and employment growth attest, there wasn't much evidence that these tax cuts had a large impact on economic growth. Quoting Bartlett again, "Subsequent research by Federal Reserve economists [1,2,3] has found little, if any, impact on growth from the 2003 tax cut." Thus, even though the tax cuts were much better targeted than in 2001, the effect on growth was still negligible.
An analogy with the government might be helpful in understanding why the tax cuts didn't have a larger effect even though they were much better targeted than the 2001 tax cuts. When the government increases taxes, it can use the money for government investment (e.g. roads, electrical systems, bridges) or for government consumption (e.g. paper for a government office, gas to run a government vehicle, or a fireworks show to celebrate an important event). If the government uses the money for investment, and uses it wisely, the enhanced infrastructure allows us to increase our economic growth rate. But with consumption spending, e.g. an elaborate government fireworks show, there may be immediate benefits to those who watch and participate, but this type of spending doesn't do anything to increase economic growth in the future.
Tax cuts, which send money in the other direction -- from government to households -- can be viewed similarly. A tax cut can be used to fund productive investment, e.g. to open a new business, or it can be used for consumption, e.g. for an elaborate private fireworks show or some other use that does nothing to enhance our long-run growth. To the extent that tax cuts are used for something other than investment, economic growth will be lower.
What other effects can tax cuts have on economic growth?
Even the part of the tax cuts used for investment purposes may not result in enhanced long-run growth. Suppose, for example, that the money is invested in housing to take advantage of rising prices, but people are unaware that the price increases are being driven by a housing bubble. This will look at the time as though growth is robust -- and this helps to explain the little bit of growth that did come about in the period before the housing bust -- but the growth disappears as soon as the bubble pops. In fact, this type of investment leads to reduced growth relative to what could have been achieved with other investments. Thus, to the extent that tax cuts helped to fuel the housing bubble, they actually harmed rather than helped long-run growth.
The Bottom Line
We are not going to solve our budget problems with spending cuts alone. Like it or not, tax increases will be required. What's unknown is the types of taxes that will be increased and who will be asked to pay them. 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.