The Tax-Cut Danger of “borrowing growth” (or, Laughing at Laffer)

"Although conventional estimates of the budgetary effect of tax policies incorporate a variety of behavioral effects, they are, nonetheless, based on a fixed economic baseline. For that reason, they do not include the budgetary impact of any possible macroeconomic effects of tax policies."

Douglas Holtz-Eakin, Director, Congressional Budget Office


We last took a long hard look at Supply Side Economics way back in December 2003. More recently, a Congressional Budget Office report ("Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates") asked an intriguing question: 

"What are the economic impacts of tax cuts on subsequent revenues for governments?"

The NYTs Dan Altman opined: "it may be one of the most important government publications in years." I suspect he’s on to something.

Why? Most predictions about the impact of tax-rate changes fail to include "the budgetary impact of any possible macroeconomic effects of tax policies." They do not to account for how the tax cuts affect the overall size of the economy, and therefore influence future government tax revenues — and ultimately, deficits or surpluses. (I wonder what Soros would say about its reflexivity?)

Altman notes that "it is this omission – one often cited by proponents of tax cuts, especially in the White House – that the [CBO] paper tries to correct."

Here’s how the math shakes  out:

"The author of the analysis, Ben Page, estimates how an across-the-board cut in income tax rates could generate higher levels of economic activity, potentially replacing lost tax revenue. The theory behind these feedback effects is well worn: putting money back into taxpayers’ pockets will let them spend more and save more, raising demand for goods and services and helping companies to invest for the future.

Mr. Page assumes that government spending will continue as planned for a decade after the tax cuts. He also creates different possibilities based on various assumptions about people’s foresight, the mobility of capital and the ways in which the federal government might make up for the lost revenue when the decade is up – either by cutting spending or by raising taxes again. Finally, he compares the budget office’s figures to those of two private forecasting firms, Global Insight and Macroeconomic Advisers.

Like many predictions in economics, Mr. Page’s vary widely depending on his assumptions – this stuff is more like weather forecasting than Newtonian physics. But even within their range, the results answer the fundamental question posed by the Laffer Curve.

The recent analysis by Mr. Page at the Congressional Budget Office dismisses the idea that tax cuts may actually improve the government’s fiscal situation. Even in his most generous scenario, only 28 percent of lost tax revenue is recouped over a 10-year period. The United States, it seems, is firmly planted on the left side of the Laffer Curve. (emphasis added)

Note this is more than mere theory. Looking at the most recent tax cuts and their impact on revenues, we learn that recent experience corroborates this prediction:

"In the second quarter of 2001, just before the first of President Bush’s tax cuts took effect, federal receipts from personal taxes accounted for 10.3 percent of the economy. By the end of the post-recession slump, receipts had dropped to 6.4 percent. But in the third quarter of 2005, with the economy booming, they were still under 7.5 percent – an enormous difference. In dollar terms, federal receipts from personal income taxes, at $802 billion in 2004, are still lower than they were in 1998 ($826 billion) and much lower than in 2001 ($994 billion)."

The bad news may be even worse. Once a shortfall begins, the government does what governments always do — Borrow more:

"Shortfalls in revenue cause the government to borrow more, so money intended for other purposes must be paid as interest instead. Even in Mr. Page’s most generous picture, the federal government would probably have to pay an extra $200 billion in interest over the decade covered by his analysis."

What is the exact nature of the trade off? Mr. Page estimates that gross national product gains about 1% in exchange for higher deficits.

In other words, Supply Side Tax Cuts "borrow" growth.

This CBO thesis essentially challneges the entire premise of the Laffer Curve and Supply Side Economics. Former CEA Chair Gregg Mankiw (now back at Harvard) implied as much in his Macro Econ textbook. Expect to hear more about this in the coming year.

This study essentially confirms one of the oldest theories in all of Economics: There is no Free Lunch . . .


With this post, we also add the category: "Taxes & Policy"


A Bit of Doodling About a Tax-Cut Danger
NYT,  January 1, 2006

Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates Tax
A series of issue summaries from the
Congressional Budget Office DECEMBER 1, 2005

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  1. RW commented on Jan 1

    It’s fascinating how ideological (& usually self-serving) commitments on the part of elites continually pushes the system into imbalances that everyone winds up paying for: From left-wing welfare statism to Reagan’s ‘Voodoo Economics” (based in part on the so-called Laffer Curve) the result of accepting fantasy or unexamined assumptions is inevitably failure. Laffer’s flight of fancy was not only mathematically trivial but also utterly failed to provide a real-world mechanism for identifying the point where taxes might be considered confiscatory. In the reality-based community it was obvious from the very beginning that continually cutting taxes without identifying the point where economic activity would respond (assuming it ever would) must ultimately leverage the future: The Republicans are now the official Borrow-and-Spend party; hope they enjoy the label as much as the Democrats enjoyed being identified as Tax-and-Spenders.

  2. nate commented on Jan 1

    In finance, more leverage can juice returns yet reduce flexibility and leave less margin for error or unexpected events.

  3. RN commented on Jan 1

    It’s a sad state of affairs today that economics is not what’s true but what you can argue.

    It’s become the leveraging of a social science to put money in your pocket today for the “economically sound” -based on your argument du jour – promise of more money for all at some unspecifed “tomorrow”.

    But as inflation, wage growth, debt, etc. numbers show, for the vast majority of people, “tomorrow” never comes.

  4. vfoster commented on Jan 1

    I am puzzled that neither the author of the CBO article nor Daniel Altman addressed what is the dirty little secrety behind supply-side economics and that is the policy is inherently inflationary. Inflation is the by-product of tax cuts and deficit spending and it affects the class structure in a totally opposite ways. The upper class, who receive the tax cuts, also own the assets that are inflated by the increase in economic activity. The working class, meanwhile sees an increase in commodity prices, a by-product of a elevated economic activity and excess liquidity in the money stock, which hits their disposable income much harder than the upper class(gas prices). The result is an increase in outstanding debt to keep up with the standard of living. The lenders of course are the upper class (and foreign central banks) earning interest and the borrowers are the working class paying interest. The result is a wider gap in the class structure that snowballs (reflexivity) in the opposite direction as inflation eventially drives up the cost of borrowing. Ron Insana says it almost everyday, “corporations are sitting on an estimated record $2 trillion in cash on their balance sheets.” Is there any cap-ex/hiring? Hell no, I think we’ll pay ourselves dividends and buy back stock to increase our ownership. But sure, we can lend them moeny to sell them something they don’t need. Supply-side economics is the backbone of the Republican agenda and it is a total fraud. The Democrats are so stupid, they can’t even figure it out……….. and as with supply-side economics and inflation, there is no free lunch and i suspect when the inflation deflates it will hurt those at the top more than at the bottom.

  5. B commented on Jan 1

    Did laugher, ok laffer, actually say that cuts would stimulate the economy enough to more than offset tax declines?

    The laffer curve surely has merit. It’s common sense. I wonder what the American economy would look like if we still had those 70%+ upper income tax rates….err whatever they were. I was still in high school so it’s a little hazy between chasing girls and evaluating economic policy. I do think it’s funny that the common sense thinking of an actor not an economist-let people keep their money-led to a great economic boom of twenty + years.

    Here’s what I would like to have debated rather than whether supply side economics, laffer curves or anything else is relevant. And I think this is where Reagan was coming from.

    Do tax cuts chance fiscal behavior of money grubbing politicians over an extended period of time? ie, We all know tax cuts create revenue shortfalls yet economic growth that may be looked at as borrowed. I choose to phrase it differently. (And I’d highly argue Reagan’s cuts resulted in more than 1% growth as Altman states, but it’s anecdotal. Of course, so is his work. lol.) But when revenue shortfalls become significant debt or deficits, does it cause politicians to reign in spending? ie, Is there a psychological impact on the nation? Not within a year. Maybe not within five years. But over time? I’m a firm believe that Washington should get as little as possible because the more they have they more they will spend. And the larger deficits they will drive because they can’t restrain spending whether tax rates are high or low.
    Thus, make them do more with less.

  6. cactus commented on Jan 1

    For the past 5 years, I’ve taught the first year econ sequence in the MBA program at a fairly conservative school. Every year, I have one quiz that asks essentially the same 2 questions: Does cutting taxes lead to increased tax revenues (as per the Laffer curve) and does cutting taxes lead to an increase in real GDP per capita?

    Some years the question is based on state level data, some years its based on federal data, and once or twice I’ve used OECD data. The data, regardless of the sample, always seems to show more or less the same thing – at tax rates observed in the real world, cutting taxes has a significant and negative impact on tax revenues and no significant impact on real gdp per capita (of course, there is an indirect effect due to the increased interest on the debt that has to be paid).

    I am not at all surprised the CBO found that we are on the left side of the Laffer curve. What does surprise me is why anyone else is surprised. My first year MBA students are able to work through the data – I’m not sure why a very large number of highly paid think tank denizens and political advisors who cannot or will not. I’m not sure which is worse.

  7. Jack K. Miller commented on Jan 1

    I’ll put my hat in the ring with Ken Fisher on this one. In Forbes some months ago, he made the argument that the US economy is actually under-leveraged. He notes that when a business can expand by borrowing funds for less than the margins produced by those funds it should do so.

    The US is in that boat. The world is willing to loan us money on the cheap. We might as well make hay while the sun is shining.

    The situation certainly has confused investors. They can’t understand how it is possible to have low inflation, very strong GNP growth and a flat (partially inverted) yield curve at 4.35%. How is it possible for the most efficient market in the world, the US Treasury market, to forecast lower interest rates while the nominal GNP is growing at 7%?

    The crash you see in these numbers is the same crash that occurred mid-cycle in 1995, GNP slowed but S&P 500 stocks gained 34.1% on the year. The budget deficits you see as out of control are smaller now (3.9% of GNP) than when Republicans took control of the House for the first time in 40 years. At the end of the 40 years, the Dems had worked public debt up to 20.8%. Public debt is now down to 14.3%.

    I dare say that most of you have dept balances greater than 14% and payments that are greater than 3.9% of your income. I’m laughing all the way to the bank.

  8. cactus commented on Jan 1


    I’m clearly not seeing the same data as you. At the White House OMB site, table 7.1 ( indicates that in 1996, the gross federal debt less that part held by government accounts and less that part held by the Federal Reserve (which I assume is what you’re referencing) was 43.5% of GDP. In 2004, the last year for which they had actual (i.e., not estimated) data, the figure was 31.1%. But, from 1996 until 2001, that figure dropped every single year, and it has risen every single year since 2001. I note that it also dropped all years from 1993 to 1996 – under a Democrat Congress, after generally rising through the 80s (it was at 21.8% in 1981 when Reagan took office). I’m not sure its the Republican Congress that is the big factor here. Simple eyeballing indicates the big changes seem to have happened in 1993 and 2001 – and it wasn’t Congress that changed in those years.

    I wouldn’t focus too much on GNP. GDP is a much better measure of the economic activity that affects most Americans. After all, generally more Americans are affected more by a Toyota plant in California than by a Nike factory in Vietnam; the former is counted in GDP but not in GNP, and the latter is counted in GNP but not in GDP.

    Finally, a criticism many people have of the administration is that it hasn’t taken advantage of the low interest rates. Instead of issuing more long term debt (France even began issuing 50 year bonds to take advantage of the very low interest rates that have prevailed over the past few years), this administration for a while retired the 30 year bonds. This is the equivalent of a homeowner last year refinancing his 30 year mortgage by taking out a 2 year mortgage in order to take advantage of the low interest rates. If your neighbor did that, you’d probably think him a cretin. You’d probably be right.

  9. D. commented on Jan 2

    Ideology vs. reality. At the end of the day, money should be entrusted to those who can manage it best.

    I believe that lower taxes are better for the economy if and only if the population actually uses the money more efficiently than government.

    But that requires a leap of faith. Enron and the tech bubble have shown us how efficient the private sector really is and the housing bubble shows us how efficient individuals are at managing their tax rebates.

  10. cactus commented on Jan 2

    I would imagine that neither the public nor the private sector is particularly efficient – both are made up of people. However, both sectors spend on different things. The government, for instance, spends on infrastructure and so forth, which are necessary for the well functioning of the economy. (As far as I know, the only country which hasn’t a functioning government for a while is Somalia, and from what I can tell nothing works there except the the mobile phone industry.)

    So, even if both sectors are equally inefficient with the average dollar, one of the sectors will be more inefficient at the margin. It may well be, because the government is relatively small in the US (compared to similarly developed countries) relative to the private sector, that the government spends its marginal dollar in a way that is more likely to boost the long term wealth of the country more than the private sector. That would certainly go a long way toward explaining why the Laffer curve doesn’t behave the way Laffer or the Reagan or this administration believes it “should.”

  11. stockman commented on Jan 2

    “The borrower shall be a slave to the lender.” – Proverbs 22:7
    (Perhaps the Chinese know the bible better than W?)

  12. RW commented on Jan 2

    Cactus makes an interesting point WRT relative size of govt in developed countries and distribution of wealth therein but I suspect a number of confounding variables exist. Why for example do developed countries with relatively high marginal tax rates and extensive social safety nets consistently do better than Laffer/Reaganomics predicts? To be sure they tend to have relatively lower growth rates (at least by measure favored in the US) but could it be that sustaining high growth rates is not the necessary and sufficient condition for economic health; or perhaps that sustaining them via leverage creates or masks fundamental problems of another sort?

    How should we interpret relative velocity of money then? Are proponents of social safety nets correct when they aver that assuring poorer citizens have more money inevitably increases economic activity because they must turn it over faster (can not hoard) and do not spend it abroad? Is the assertion correct that universal health care coverage would reduce the cost of doing business in the US?

    I actually have far more suspicions than answers but the larger suspicion is that a number of factors, including the growing disparity between the owners of capital and everyone else in the US, are telling us something we must assess honestly and interpret correctly; i.e., if ALL the relevant numbers fail to confirm a theory’s predictions then that theory must either be modified or abandoned. Simply coming up with a bunch of auxiliary theories that say you should only look at these numbers this way or that the numbers are really saying this rather than that is only a mechanism for protecting the core assumptions required by a specific ideology underlying the central theory: It is impossible to make progress that way.

  13. Colin commented on Jan 2

    It requires a leap of faith to think that the private sector can manage money better than the government? Are you kidding me? I think that debate was settled when the Berlin Wall fell, if it wasn’t already apparent.

    While one can certainly find anecdotal information about private sector failings, in government they are legion as even a cursory examination of a farm bill, transportation bill or energy legislation will prove.

  14. cactus commented on Jan 2


    The relevant question is – is the government more effective at using the marginal dollar to boost long term growth or is the private sector? If so, we are better off with higher taxes, if not we are better off with lower taxes.

    Obviously, if the government controls almost everything as happened east of the Berlin Wall, the government is probably not going to be more efficient at the margin. But if the government is too small, you don’t have the spending on infrstructure, etc., that is also necessary for growth. A number of Northern European countries have much higher tax rates than we do and some do quite well. (The GDP per capita in Luxembourg is higher than ours – I think so is Norway’s and perhaps Sweden’s and Finland’s as well.)

    The fall of the Berlin Wall doesn’t mean that the Norwegians are doing it wrong, any more than the mess in Somalia indicates that cutting taxes in the US is a bad idea. Somewhere along the line, there is happy medium, and it may even be that the happy medium is closer to Norway than it is to the US. (And it may be that there are cultural norms adjusting that happy medium.) Every year my students seem to find that that’s what the data says for some reason.

  15. Barry Ritholtz commented on Jan 2

    I like the concept that at different points in the cycle, different entitities are most efficient — government spending during recessions, followed by (pent up) consumer spending early in a recovery, and then corporate Capex & hiring.

    The timing is key to the cycle expanding or fading . . .

  16. jd commented on Jan 3

    The question posited is only intriguing if its converse is also considered:

    “What are the economic impacts of tax INCREASES on subsequent revenues for governments?”

    Also, the question demands full context for all the variables involved–how is the impact changed by where the tax changes are implemented (i.e. corporate, personal, etc.)? Which supply side cuts, if any or all, borrow growth? Do ALL tax cuts result in borrowed growth or is it just the current combination of tax vehicles?

  17. kharris commented on Jan 3

    Didn’t Holtz-Eakin run a similar study on a single budget, under orders from his bosses? His own conclusion was similar in nature to the conclusion reached by Page. H-E turned out to have a spine like a cedar, never coming up with a politically convenient answer in preference to the right answer. Now that is out, it’s good to see his legacy remains.

  18. Barry Ritholtz commented on Jan 4


    Reagan raised taxes in his 2nd term; Bush I raised taxes — he got voted out, but the economy was already in an upswing — if the election was 3 months later, he might have won. and Clinton raised taxes.

    Too much in the way of tax hikes oppress growth; too little taxes cause deficits. The happy medium is ideal.

    Unfortunately, the idealogue/doctrinaire tax cutters donot understand that; On the other side, neither due the spending whores in Congress.

  19. Chad K commented on Jan 4

    What I want to know is…

    If there is no positive or negative economic impact on lower taxes… then it seems like that in itself is a positive. So, why should be be paying more rent just to live on earth?

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