Wednesday, May 10, 2006

Are the Bush Tax Cuts Progressive? You Make the Call.



It all started with an op-ed in the Wall Street Journal by Edward Lazear and Katherine Baicker, which stated, in part, that "the president's tax cuts have made the tax code more progressive."

Lazear is a Stanford economics professor who took over as the chairman of President Bush's Council of Economic Advisers after the president nominated the previous chairman, Ben Bernanke, to head up the Federal Reserve. Before Bernanke, the post was held by N. Gregory Mankiw of Harvard University. Soon after the op-ed hit the pages, Mankiw explained on his blog why it's difficult to say whether a tax cut makes the tax code more or less progressive:

There are two people. A rich guy earns $200,000. A poor guy earns $20,000. At first, the rich guy pays $50,000 in taxes, and the poor guy pays $1,000. Then a new President takes office and cuts the rich guy’s taxes to $48,000 and the poor guy’s taxes to $800.

Who is getting the better deal?

  • You could say the rich guy gets the better deal: The rich guy gets an extra $2000 in take-home pay, while the poor guy gets only $200. After the tax cut, the difference in take-home pay between the two guys is larger.
  • You could say the deal is evenly balanced: Everyone gets to keep an extra 1 percent of his income.
  • You could say the poor guy gets the better deal: The poor guy gets a 20 percent tax cut, while the rich guy gets only a 4 percent tax cut. After the tax cut, the rich guy pays a larger share of the total tax burden.

It is impossible to say on purely economic grounds which of these
perspectives is better. All of these statements are mathematically correct, even
if they leave the reader with a very different impression.

Not so fast, replied Berkeley economist Brad DeLong on his blog:

Let me try an analogy. I, full professor Brad DeLong, am having lunch with lecturer Dariush Zahedi today. After lunch, I presume Dariush will say we should split the bill--$10 each. Suppose I say: "That isn't fair. Berkeley pays you less (a lot less: what we do to our lecturers is shameful) than it pays me. I should lay out more cash for this lunch. How about this: I put down $5 cash, you put down $0, and we put the balance on your credit card. That would be fairer, wouldn't it?"

Dariush would then be an unhappy camper. He would think--correctly--that I was mocking him.

[The U.S. is] running a deficit of $300-$400 billion a year…That bill will come due: somebody has to pay it. To pretend that it won't--to pretend that you can talk about the progressivity of the burden of paying for the federal government without talking about the long-run incidence of the national debt--well, that would be the equivalent of me telling Dariush that only cash matters: that when we talk about who paid for lunch, we should count only cash put down now, and we shouldn't count the fact that his credit card bill will show an extra $15 due next month.

Is one of these economists right, and the other one wrong? It's not that easy, and understanding why is important. As with any economic question, the answers depend on the model you choose to analyze the situation at hand. Mankiw's model is static: a given tax cut within a given time frame may be viewed as progressive, neutral, or regressive. DeLong's model is dynamic: the overall progressivity of a tax cut depends not only on its effect on income today, but on its effect on future incomes as well. Both economists take their respective models to their appropriate conclusions.

The debate is not, therefore, over whether Mankiw and DeLong make incorrect statements, given the models they choose for their analysis--they're both far too smart to do that. Instead, the debate is over who has chosen more appropriate assumptions. In other words, which story--the one about the two guys who receive tax cuts, or the story about the two professors at lunch--is more useful in analyzing the progressivity of the Bush tax cuts?

Having said all that, it's also important to understand how each economist is "stacking the deck" in the choices of numbers he makes in his model. To illustrate this, think about the following two questions.

1. In Mankiw's example, tax revenues are reduced by a total of $2,200. Mankiw chooses to show the case in which that split is $2,000 from the rich guy and $200 from the poor guy. How would his analysis change if that split were different--say, $2,100 from the rich guy and $100 from the poor guy, or $1,100 from each? Would it become less ambiguous as to whether the tax cut were progressive or regressive? (In other words, while it may be difficult to say whether the Bush tax cuts are progressive or regressive in absolute terms, is it possible to say that other policy options would have been more progressive or regressive?)

2. DeLong argues that Mankiw ignores the long-run incidence of the national debt. The "incidence of the debt" simply tells us who pays the credit card balance. In DeLong's example, the poor lecturer gets stuck with the whole credit card bill. That's like assuming that future taxes are more likely to be borne by the poor than the rich. How would DeLong's argument be altered if the rich paid more of the future taxes? For example, suppose we started out with a "progressive" split: DeLong pays $12 and Dariush pays $8. DeLong suggests that instead, Dariush should pay $6 now and put $1 on his credit card, and DeLong will pay $8 now and put $5 on his credit card. This yields a more regressive split of cash (DeLong pays 1/3 less cash and Dariush pays 1/4 less cash), but a very progressive allocation of debt.

Updates

The two articles cited above have ignited a small firestorm on the internet. Here are just a few of the greatest hits.

Brandon Berg responded to Mankiw, arguing that his first two postulated methods of measuring progressivity of a tax cut are flawed because "they both allow us to eliminate the poor guy's tax burden altogether while making the system less 'progressive.'"

Jane Galt responded to DeLong, aruging that when the tax bill comes due, she finds it much more likely, in a political sense, that taxes will be raised on the rich to pay for it. (DeLong responded to her, briefly, suggesting that her argument implies that Bush is a "redistributionist mole"-- a scenario he doesn't feel is very likely.) PGL of Angry Bear pointed out that Galt's point was analyzed in a paper entitled "The Ultimate Burden of the Tax Cuts" by William Gale, Peter Orszag, and Isaac Shapiro, who argued that while it is true that future burdens are more likely to be borne by the rich than the poor,
...the [Bush] tax cuts scale back (or even eliminate) many of the most progressive elements of the federal tax system, including the estate tax, the taxation of capital gains and dividends, the top income tax rates, and the phase-outs of certain exemptions and deductions for households with high incomes. It is unlikely that any method of financing those changes, other than repeal, will be as progressive as the tax provisions that have been scaled back.
Mankiw then addressed Galt and DeLong with a long post entitled "The Progressivity of Budget Deficits," concluding that "saying whether and why deficits are undesirable requires judgments that are more philosophical than economic."

Jason Furman wrote a letter to the Wall Street Journal saying that regardless of the niceties of these arguments, the numbers in the case of the Bush tax cut are clearly regressive:
According to the Tax Policy Center, the tax cuts passed since 2001 have raised the after-tax income of the top 1% of Americans by 5%, while raising the after-tax income of the bottom 60% of Americans by just 2%. In other words, the tax cuts have contributed to widening, not narrowing, the difference in take-home earnings.
Mankiw responded to Furman with a detailed mathematical analysis.

I'm sure that this debate will continue...

Topics: Public finance, Taxes, Equity, Model selection

2 Comments:

  • At 9:22 PM, May 11, 2006, Blogger brad said…

    The argument that a tax cut for the rich is ultimately progressive because it runs up the debt and creates a political backlash that ultimately leads to bigger tax increases for the rich than the tax cut has been made by Jane Galt. See:

    http://delong.typepad.com/sdj/2006/05/jane_galt_says_.html

    If you think that this is the long-run strategy of the Bush administration, I have a bridge I would like to sell you.

     
  • At 10:38 PM, May 11, 2006, Blogger Chris Makler said…

    Thanks for the link, Brad! Jane makes an interesting point.

    I agree with you -- as, I imagine, both Jane and Bush would -- that provoking such a backlash is not the long-run strategy of the Bush administration. (Would such a tactic be called a starve-the-beast-so-it's-really-hungry-and-binges-later strategy?) But a variant of her argument does seem plausible: namely, that ANY tax cut that results in a deficit ends up being more progressive than it was intended to be, since when the debt needs to be repaid it's more politically expedient to raise the money from the rich. I'm not aware of any research on this particular issue; are you?

     

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