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Thursday, April 03, 2003

Dynamic Scoring Blues-Jane Galt reports on the CBO using dynamic scoring on the Bush budget and disappointing the supply-siders by saying that it will reduce revenues. One of the commenter asked " can you explain why supply-side tax cuts do not pay for themselves?” Here’s my shot. Tax cuts would work in two areas; the first is the decision of how much to work, where you have a tradeoff between work and leisure, as people have to choose between working more for more stuff or having time to enjoy the stuff. A tax cut will give you more take-home pay and give a greater reward for extra work. We have two things to take into account; the substitution effect and the income effect. The substitution effect would have people working harder if the cost of leisure was increased; lowering taxes will increase people’s per-hour take-home pay and make leisure more expensive. However, the tax cut will also raise people’s take-home pay, allowing them to “buy” more leisure by working less. So, will people work harder if you cut taxes? A lot depends on how much leisure is a normal good, one that people buy more of as they get wealthier. As people get wealthier, time off seems to be more valuable than extra pay. Our economic theories assume that work can be added incrementally; it's hard for more people to choose to work 38.1 or 42.3 hours to maximize their utility. The dificulty of adding hours might make the effect of people leaving the workforce for school or homemaking via the income effect bigger than the effect of people reintering the workforce or working more hours due to the substitution effect. A tax cut might allow a mom to stay at home or a student go to summer school rather than work over the summer. I’m not sure how the CBO sees the labor supply increasing due to this proposal. If anything, tax cuts would tend to decrease the labor supply. The lower taxes might lure some people out of retirement or school or homemaking, but they are more likely to give households the purchasing power to allow members of the household not to work. If people respond to a tax cut by working less and getting the same take-home pay, a tax cut would then reduce personal wage income, while likely increasing the take-home pay. However, we have yet to look at the effect on investment. The decision to invest or spend is a question of goodies now versus more goodies later. People will tend to invest more if taxes have been lowered for two reasons. A lower tax rate will give them more take-home pay to invest and also increase the appeal of investment since the after-tax return on investments will have gone up. If the pool of investable funds goes up more than the added deficit, you will see increased investment in the private sector. Investment will likely go up, but the private capital stock might go down if the deficit spending is bigger than the added investments. In the case of investments, both the income and substitution effects lend themselves to higher investments that will bode well for income in future years. The short-term effect of the tax cut will lead to decreased revenues, as it is unlikely that investment income will offset the loss in wage income from the cuts. However, if the investments are fruitful, the demand for labor will increase and wage income will go up in time as well, as more people will be employed to help utilize the extra capital. This extra productive capacity will increase GDP via both wage and investment income and will dampen the revenue losses in later years. So, in the short-term, the tax cuts aren’t going to start to pay for themselves, but in the long term, they will start to increase GDP to the point where they might pay for themselves. Even if they don’t quite pay for themselves, we’ll have a stronger economy, and we’re looking to maximize overall well-being and not tax revenue.

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