What Effects Have the Recent Tax Cuts Had on the Economy?

Publication Date: July 2004

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

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Abstract:

Congress enacted major tax cuts in 2001, 2002, and 2003. The acts reduced marginal income tax rates; reduced taxes on married couples, dividends, capital gains, and on estates and gifts; increased the child tax credit; and accelerated depreciation for business investment. The tax cuts resulted in an estimated revenue loss of 0.4% of GDP in 2001, 1.1% in 2002, and 1.6% in 2003. Most of the tax cuts are scheduled to expire after 10 years, but proponents intended that they be permanent. Since government spending rose as taxes were cut, the cuts can be characterized as deficit financed.

It is hard to be certain what effects the tax cuts have had on the economy because there is no way to compare actual events to the counterfactual case where the tax cuts were not enacted. The most common method of estimating a tax cut's effect is to feed it into a macroeconomic model of the economy and see what the model predicts. Note that this is typically done before the fact: economic estimates of the tax cut's effect are not based on actual ex post data. These estimates are highly uncertain since there is no one macroeconomic model that adequately captures all of the economy's dynamics, no consensus among macroeconomists as to which one model is most suitable for policy simulations, and no model with a strong track record in accurately projecting economic events.

Most estimates predict that the tax cuts will increase economic growth in the short term and reduce it in the long run. For example, the Joint Committee on Taxation predicts that the 2003 tax cut will increase GDP by an average of 0.2 to 0.5% in the first five years and decrease it by -0.1 to -0.2% over the next five years. Keynesian models find the largest positive short-term effect of the tax cuts on the economy. But these effects are completely temporary because they focus on how tax cuts boost aggregate spending; in the long run, prices adjust, and production rather than spending determines the level of output. In neo-classical (Solow) growth models, deficit-financed tax cuts reduce national saving, thereby reducing national income because capital investment can only be financed through national saving or foreign borrowing. If the latter occurs, the result will be an increased trade deficit. In intertemporal models, a deficit-financed tax cut is unsustainable: it must be offset in the future by a tax increase or spending cut to prevent the national debt from growing indefinitely. Thus, in these models tax cuts followed by tax increases lead individuals to shift work and saving into the low-tax period, increasing growth, and out of the high-tax period, reducing growth.

The period encompassing the tax cuts featured a recession of average duration but below-average depth, an initially sluggish recovery, a deep and unusually long decline in employment, a small decline in hours worked, a sharp and long lasting contraction in investment spending, a significant decline in national saving, and an unusually large trade deficit. Opponents see this as evidence that the tax cuts were ineffective; proponents argue that the economy would have performed worse in their absence. One should also consider that some, perhaps most, of the recovery was due to monetary rather than fiscal stimulus. (This report will not be updated.)