Effects of the Tax Cut on Saving

"The reduction in marginal tax rates implied by the 2002 tax legislation may not decrease revenues as much as the 'static' methods used by government agencies to estimate revenue losses suggest."

Washington is still debating the politics, economics, and merits of the substantial tax cut initiated by President George W. Bush and passed by Congress, with amendments, in 2001. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) reduces ordinary income tax burdens but leaves more taxpayers exposed to the Alternative Minimum Tax (AMT). Also, the tax cut "sunsets" after 2010. Some debate its short-run macroeconomic consequences, with respect to both its timing and whether its "back-loaded" structure undercut its ability to spur economic activity during the recent economic downturn.

In The Bush Tax Cut and National Saving (NBER Working Paper No. 9012), NBER Research Associate Alan Auerbach specifically examines one side of its incentive effects, its impact on savings. One of his basic findings is that the reduction in marginal tax rates implied by the 2002 tax legislation may not decrease revenues as much as the "static" methods used by government agencies to estimate revenue losses suggest. Still, he writes, "it is difficult to put together a combination of reasonable assumptions regarding household and government behavior under which this tax cut will increase national saving and capital formation." That's important, because extra savings can boost future productivity and living standards by deepening the supply of capital used by business to purchase plant and equipment. An underlying motivation for many in pursuing this tax cut was the notion that lower taxes can spur private activity and make the economy more productive.

Auerbach focuses on the net national saving rate - the share of net output that is consumed by neither government nor households - as a summary measure of the nation's rate of capital accumulation. He uses a "dynamic" model that takes account of any feedback on the economy in the way of extra economic growth, and thus additional government revenues, stimulated by a cut in marginal tax rates. His simulations suggest that the Bush tax cut may increase saving in the short run, depending on assumptions. Also, it is likely to increase economic output in the short run, because of its additional salutary effects on labor supply. With lower tax rates, individuals are encouraged to work more and those with higher incomes are able to save more. These dynamic feedback effects are significant: they offset as much as 10 to 40 percent of the revenue losses imputed by static calculations of the impact of the tax cuts.

But they are not large enough to offset the negative impact of tax cuts on national saving. In the longer run, saving and output are likely to fall once the revenue losses generated by the tax cut are confronted through necessary policy changes. Those could include tax hikes or spending cuts to reduce federal deficits. Only if the revenue losses are entirely offset by reductions in government consumption spending can the long-run drag on the economy be avoided, Auerbach finds.

To reach these conclusions, Auerbach looks at a number of alternative assumptions about post-2010 fiscal policy. They assume, for example, that the tax cuts remain in place for varying time spans, from the original 10 years to 20 years. But none assume the tax cuts will be made permanent, as that would imply the government will allow its national debt to explode unless stronger growth raises revenue enough to eliminate future deficits.

-- David R. Francis

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