Why Christina Romer is wrong on taxes

July 5, 2011

President Obama’s economic all-star team from 2009 is all but gone. But it’s the gift that keeps on giving. In yesterday’s NY Times, former White House economist Christina Romer offered a rather strange op-ed in favor of tax increases. The crux of her argument is this:

The economic evidence doesn’t support the anti-tax view. Both tax increases and spending cuts will tend to slow the recovery in the near term, but spending cuts will likely slow it more. Over the longer term, sensible tax increases will probably do less damage to economic growth and productivity than cuts in government investment.

And her evidence?

Some in Washington and in the news media have seized on a study I conducted with David Romer, my husband and colleague, that they say shows tax increases having a bigger short-term effect on the economy than spending cuts. Our study, which examined only federal tax policy, found that conventional analysis underestimates the effect of tax changes on the economy substantially. The key problem we address is that changes in taxes are often linked to what is happening in the economy.

That Romer-Romer study offered this conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent. Our many robustness checks for the most part point to a slightly smaller decline, but one that is still typically over 2.5 percent

Right, tax increases hurt economic growth. Agreed. And they may only raise half of the revenue predicted by static analysis that does not take into account behavioral effects. But then Romer makes this claim:

If there were a similar study on government spending, it would likely show that spending cuts also have larger effects than conventionally believed. Like tax actions, spending changes are often correlated with other factors affecting economic activity. For example, large cuts in military spending, like those after World War II and the Korean War, were typically accompanied by the end of wartime taxes and production controls. Those probably lessened the economic impact of the spending cuts, leading many researchers to underestimate the reductions’ effects.

It is hard to argue against a hypothetical study. But Romer’s reasoning, though flawed, is hardly novel:

1) She states that, at least over the short-term, $100 less in government spending reduces aggregate demand by $100. On the other hand, a $100 tax increase on “wealthier households” does not reduce demand by $100 since at least part of that tax increase would be paid from savings rather than consumption.

Me: Been there, done that. This is sort of the flipside of the Keynesian argument in favor of the $800 billion Obama-Romer-Bernstein stimulus plan.  Except she uses a smaller fiscal multiplier here , 1.0, than she used in analyzing potential impact of the stimulus plan, 1.6. But even that may be too high. Economist John Taylor thinks the multiplier is about 0.5. In fact, there are several models that find such a low multiplier.

Unfortunately, we find substantially smaller government spending multipliers than those used by Romer and Bernstein. For example, the multiplier associated with a permanent increase in government spending by the end of 2010 lies between 0.5 and 0.6. In other words, government spending does not induce additional private spending but instead quickly crowds out private consumption and investment.

We also provide an assessment of the impact of the American Recovery and Re-investment Act. This legislation implies measures amounting to $787 billion and spread over 2009 to 2013 but peaking in 2010. Our estimate of the total impact is closer to 1/6 of the effect estimated by Romer and Bernstein. By 2010 we project output to be about 0.65% higher. Using the same rule-of-thumb as Romer and Bernstein, this increase in GDP would translate to about 600,000 additional jobs rather than three to four million.

2)  Next, Romer says that while “higher tax rates reduce the rewards of work and investing,” raising current tax rates by 10 percent would only reduce reported income by 2 percent.

Me: Again, I am not sure whose taxes she is talking about, but research by Martin Feldstein on the 1993 Clinton tax increase found that a) high-income taxpayers reported 8.5 percent less  taxable income than if their taxes had not been raised, which resulted in b) the tax increase only raising about one-third as much dough as Team Clinton has predicted.

3)  Romer also worries that “certain spending cuts may also have small effects on long-run growth.” She’s talking about stuff like basic scientific research, education and infrastructure.

Me: Ah yes, the “good” sort of spending. But as I have noted before, McKinsey consultants have found that if the U.S. public sector could just halve the productivity gap with the private sector, its productivity would be as much as 15 percent higher and would generate annual savings of up to $300 billion a year. We’re far from cutting into the muscle and bone. And there’s no reason not to take a look at basic research, infrastructure and other investment spending to see if they could be done  more productively.

Bottom line: But the basic problem here is that Romer, like the rest of Obama’s all-star team, is worried about stimulating consumer demand rather than encouraging — by the removal of tax and regulatory barriers – established businesses and new entrepreneurs to invest, expand, hire and create. And talk of raising taxes distracts from the real work that needs to be done to reduce spending. Whenever economists talk about the need to raises taxes, they are actually making a political argument rather than an economic one.  Either they are ideologically opposed to smaller government or they don’t believe Washington will ever cut spending. But that isn’t surprising since there really isn’t a valid economic argument to support the long-term Obama spending binge.


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