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Economist analyzes Dudley job plan

September 20, 2010

By Patrick Emerson
Oregon Economics Blog

Chris Dudley, Republican candidate for Governor, presented his 20-point plan for promoting employment and the Oregon economy. [Funny how these things always miraculously come out to nice round numbers – why not a 19 or 23 point plan?]  Anyway, the key points appear to be decreasing taxes and in particular capital gains taxes, (many of the other points are bromides rather then specific proposals).  This makes sense politically, after the passage of Measures 66 & 67 taxes are an obvious focal point for Republicans.  But do they make sense economically?  Perhaps.

When I first heard the news reports on the plan the sound bite they chose to play was of Dudley trying to make the point that the tax cuts would likely pay for themselves in terms of extra revenue.  To me this sounded like the tired Laffer curve argument that has been discredited for marginal income tax rates as low as we have in the US.

As an aside, if you are wondering about income tax rates and the disincentive to work, most economic studies put the tax rate at the peak of the revenue curve (i.e. after which revenues actually decline when you increase the rate) at over 70%.  Here is perhaps the foremost expert on the matter, Emmanuel Saez of UC Berkeley, quoted in the Washington Post:

The tax rate t maximizing revenue is: t=1/(1+a*e) where a is the Pareto parameter of the income distribution (= 1.5 in the U.S. and easy to measure), and e the elasticity of reported income with respect to 1-t which captures supply side effects. The most reasonable estimates for e vary from 0.12 to 0.40 (see conclusion page 47) so e=.25 seems like a reasonable estimate. Then t=1/(1+1.5*0.25)=73% which means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed

And here is a passage from Greg Mankiw’s textbook:

Laffer’s argument may be more compelling when considering countries with much higher tax rates than the United States. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work.

But you should note that Saez’s analysis is a static one, not considering the long-term growth effects of tax cuts.  Perhaps by promoting growth in the long-run, over time cutting taxes will promote growth.

Capital gains taxes are more nuanced than the tax rate on labor income since capital gains taxes are on often associated with the very investments that we think are good for economic growth, especially in productive capacity.   We want to encourage investments in new businesses and in revenue enhancing productive capacity, and one way to do so is to increase the reward on such investments – by lowering the tax rates.  There are also many other types of investments that fall into this category that are not so obviously growth enhancing like buying and selling stock.  If the share price goes up, the investor makes a capital gain, but this gain does not necessarily represent an investment in productive capacity.

So what is the answer, will this pay for itself?  The first part is pretty clear: in the short-run we should expect tax revenues to decrease.  The second part, the question of whether the cuts will this enhance growth in the state enough over time so as to raise tax revenues to a level higher than they would have been without them, is not clear.  And no good answer exists to this question.

Here is the conclusion form a CBO report on capital gains taxes and growth:

Revenue estimators are often faulted for the way they project tax receipts and prepare legislative cost estimates related to capital gains taxes. But the relationship of realizations and receipts to gains tax rates is neither predictable nor obvious. And while reductions in the overall taxation of capital income can measurably increase economic growth, a cut in capital gains taxes alone is likely to produce much smaller macroeconomic effects. Inaccuracies in projecting revenue and disagreements about the effects of tax changes stem not from a failure to incorporate the behavioral responses of asset holders but from the complexities inherent in the nature of gains and gains realizations.

So in the end, we don’t really know, especially in the case of a state as opposed to a country. I think one could target specific investments in new business, new capital, etc. and exclude things like earnings from stock sales and have a smaller short-term revenue impact while getting the growth boost you are hoping for.

And this is getting too long, but my first impression is that the tax credit for businesses who hire unemployed workers is a very good proposal as a temporary measure.

  
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