Andrew Cooper, the chief economic adviser to the 2016 presidential campaign of Hillary Clinton, wrote an article last weekend in the Economist stating that Bill Clinton was right about taxes in 1993: cutting them would help to support the economy without hurting people. Mr Cooper, a former economic adviser to Clinton, cited old studies from the Council of Economic Advisers and Commerce under Clinton; and a 1994 study of the Treasury’s Bureau of Labor Statistics, “The macroeconomic consequences of changing marginal tax rates for wages and salary income” by John Cochrane.
The article fails to mention two further critical studies. One study was undertaken by economists at the University of California, Davis, in 2000, and another by Henry Aaron, a former Clinton administration economist. They found that adding just a few percentage points of personal income tax would have a very substantial effect.
The largest study to date was conducted by David Merritt of the CEA in 1994 (working with a team at State University of New York at New Paltz), when Clinton was still running for president. The report concluded that “the direct impact of reducing the top tax rate to 30 percent from 39.6 percent will be negligible.” Of the (small) benefits of lowering the top income tax rate to 35 percent, the paper found “nothing substantial” (see http://camps.stat.usgnu.edu/document.aspx?dam=documents&id=L&ss=8&rdid=v1&type=pf) — no increase in government revenues (despite a 3 percent pay raise and smaller losses in tax revenues) and no effect on economic growth, with new research suggesting that Bill Clinton was wrong about the impact of cutting taxes on earnings.
As for Mr Cooper’s study, it did not examine changes in marginal tax rates for non-wage income, such as capital gains (which are taxed at a maximum rate of 0 percent). He did not mention a large and somewhat overlooked study by Irwin Stelzer of the General Accounting Office (GAO) in 1995, a top advisor to Clinton on economic policy, which estimated that tax rates were indeed having little or no effect on real GDP in the late 1990s (see http://www.gao.gov/resource/00-29901_90_final_report.pdf). Mr Stelzer thought that given the very small historical impact of reducing the top marginal income tax rate to 35 percent, any effective marginal tax rate reductions from the top marginal tax rate range of 18 percent to 25 percent would be largely for financial effects. Accordingly, he found that a 4 percent rate cut would increase economic output by .1 percent in every year, with much smaller increases in personal income tax revenues. And this is before inflation.
Mr Cooper was asked recently by the Wall Street Journal to explain his article. He replied that he was trying to distinguish between the imponderable “mental models” of economists and what is likely to be an impact of marginal tax rate changes. In other words, he said that the higher taxes that Bill Clinton was proposing to impose would make people less rich, while tax cuts would not affect the rich at all. And he claimed to not have a clear answer as to which would have the larger effect. One simple question could settle the matter: if a tax cut happened to cause people to be less rich, would that reduce their economic fortunes overall? If the answer was “no”, then the effects of lowering marginal tax rates could be large, even if the effects of those cuts were small on absolute terms (higher rates do tend to reduce discretionary spending and thus cause slower economic growth). If, on the other hand, a tax cut increased people’s economic fortunes in the long term, the impact of lower marginal tax rates would be small. If a tax cut reduces people’s actual economic fortunes in the short term (saving or investing, for example), then lower marginal tax rates would very likely boost aggregate demand and therefore the economic output in the short term.
What this means is that, in contrast to what Mr Cooper claims, budget deficit and economic growth are interlinked. Fears that the Obama administration’s fiscal contraction in the aftermath of the financial crisis was a macroeconomic accident have been overblown. Worrying about budget deficits, and therefore about the economy, is a premature exercise. Austerity without greater confidence that the economy is growing might be the recipe for disaster. There is a good precedent for this attitude. Look no further than the Clinton era.