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“Do Tax Cuts Starve the Beast?” by Christina Romer and David Romer Remarks by Steven J. Davis University of Chicago Brookings Panel on Economic Activity.

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Presentation on theme: "“Do Tax Cuts Starve the Beast?” by Christina Romer and David Romer Remarks by Steven J. Davis University of Chicago Brookings Panel on Economic Activity."— Presentation transcript:

1 “Do Tax Cuts Starve the Beast?” by Christina Romer and David Romer Remarks by Steven J. Davis University of Chicago Brookings Panel on Economic Activity April 2-3, 2009 Washington, DC

2 Starving the Beast – What Is the Mechanism? Debt servicing requirements are a claim on government revenues. Assumption: Rising marginal costs of raising government revenue and non-increasing marginal benefits of spending (for PM) Implication: OTE, a government that inherits more debt spends less, net of debt servicing. Mechanism: Bequeath more debt to future government, raise servicing costs, and thereby limit future spending

3 Strategic Beast Starving 1.Current PM anticipates that future PM has a stronger taste for public spending – Compared to situation where current PM expects to retain power, current PM taxes less and runs a bigger deficit. – Why? To constrain future spending. – Persson and Svensson (1989, QJE) 2.Current PM anticipates that future PM wants a different type of spending – Compared to situation where current PM expects to retain power, current PM spends more on its preferred type of spending and runs a bigger deficit. – Why? To constrain future spending on the type of spending that current PM dislikes. – Alesina and Tabellini (1990, RESTUD)

4 No Starvation Diets in this Sample If deficit-financed tax cuts raise debt-GDP ratio by 5 percentage points and r=2% per year, then debt servicing costs rise by (.05)(.02)=0.1% of annual GDP  Desired non-interest spending falls by 0.1% of GDP if MB of G is flat, less if MB declines with G Even less strain on government revenue requirements if tax cuts stimulate growth. More strain if higher debt causes  r Conclusion: Mechanism is too weak for detection by RR method in sample of postwar U.S. tax changes.

5 Another Mechanism Tax changes are sticky – hard to reverse Magnifies force of basic mechanism, because tax changes implemented by current PM carry forward Large # of tax changes documented by RR suggests limited stickiness for “routine” tax changes Stickiness could be a very important factor for out- of-sample changes – Elimination of corporate income tax system – Adoption of VAT or national sales tax

6 What’s the Beast? “Big G” or “Big Welfare State”? Reagan opposed Big WS, favored defense Many other advocates of beast starving are more concerned about Big WS than Big Defense If Big WS is target, a focus on total G can mislead – Reagan cut taxes and initiated a persistent rise in defense spending – Both created fiscal pressures to restrain WS, but the rise in defense spending muted decline of total G Another issue: If defense spending is less responsive to fiscal pressures, then beast-starving effects load disproportionately onto WS spending. – In line with Figure 5.d

7 Deficit-Fighting Tax Hikes Often accompanied by modest spending cuts Example: Clinton tax increase of 1993 RR regard these changes as uninformative about starve-the-beast hypothesis, because they reflect a “switch to fiscal responsibility” But the need for deficit-fighting tax hikes and spending cuts, when caused by deliberate tax and spending decisions of previous PM, is evidence for strategic beast-starving behavior. – Persson and Svensson (1989)

8 Concerns about Counterfactuals and Exogeneity 1.Suppose PM foresees rising political pressure for public spending (e.g., because of population aging) – In response, PM cuts taxes now to limit or slow future spending growth. – Spending grows, but less so because of tax cut – RR interpret this pattern as evidence against starve-the-beast effects, even if the tax cuts restrain spending growth. 2.Suppose tax cuts are more likely when PM foresees strong growth and a lessening of fiscal pressures – In response, PM cuts taxes now and expands spending over time. – RR interpret this pattern as evidence against starve-the- beast effects, even though both tax cuts and spending growth reflect anticipations of strong growth

9 Summary An admirable effort, but not persuasive – Concerns about exogeneity and counterfactuals – Large standard errors – Too little variation to detect effects of mechanism – Issues related to defense spending vs. WS spending Figure 5.d says long run nondefense spending falls by 40% of tax cut amount (big standard errors) A priori reasoning implies the basic mechanism is weak for tax change episodes in postwar U.S. Frequency of tax changes suggests that stickiness mechanism also lacks force for routine changes Nothing here diminishes Becker-Mulligan-type concerns about spending consequences of VAT and other efficient taxes.

10 References Becker and Mulligan, 2003, “Deadweight Costs and the Size of Government,” J Law&Economics Alesina and Tabellini, 1990, “A Positive Theory of Fiscal Deficits and Government Debt,” RESTUD. Persson and Svensson, 1989, “Why a Stubborn Conservative Would Run a Deficit,” QJE. Romer and Romer, 2009, “Do Tax Cuts Starve the Beast?” BPEA, forthcoming.


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