Tax policy can change the size of the future economy
in either of two ways: by affecting the underlying growth
rate or by creating a one-time permanent shift in the level
of economic activity (without affecting the underlying
growth rate). In this article, both effects will be considered
to imply an effect of taxes on long-term economic
growth. The tax cuts' effects on long-term economic
performance, however, is distinct from their ability to
stimulate the economy in the short run. In the short run,
in an economy operating with excess capacity, increases
in aggregate demand can raise output and income even
without increasing the capital stock. In the long run,
however, economic growth reflects increases in the capacity
to generate income through technological change,
and the increased supply and better allocation of labor
and capital. A subsequent article in this series will
address the short-term, stimulative effect of the tax cuts.
The net effect of the tax cuts on growth is theoretically
uncertain. The tax cuts certainly offer the potential to
raise economic growth by improving incentives to work,
save, and invest. But the tax cuts also create income
effects that reduce the need to engage in productive
economic activity, and they subsidize old capital, which
provides windfall gains to asset holders that undermine
incentives for new activity. Also, making the tax cuts
permanent would raise the deficit over the medium term,
in the absence of any offsetting revenue increases or spending cuts. The increase in the deficit will reduce
national saving—and with it, the capital stock owned by
Americans and future national income.
Several studies have quantified the effects noted above
in different ways and used different models, yet all have
come to the same conclusion: Making the tax cuts permanent
is likely to reduce, not increase, national income
in the long term unless the reduction in revenues is
matched by an equal reduction in government consumption.
And even in that case, a positive impact on longterm
growth occurs only if the spending cuts occur
contemporaneously, which has decidedly not occurred,
or if models with implausible features (like short-term
Ricardian equivalence) are employed.
Section II discusses the channels through which tax
policy can affect economic growth. Section III discusses
how well the 2001 and 2003 tax cuts exploit those
channels. Section IV surveys aggregate analyses of the
tax cuts' effects on growth. Section V discusses evidence
from ''bottom-up'' studies and analysis of particular
sectors, like corporations and entrepreneurs. Section VI
discuss other perspectives on taxes and growth. Section
VII provides concluding remarks.
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