Thursday, September 6, 2007

Economic Mythmaking: Tax Cuts and Income

Matt Yglesias approvingly posts Jason Furman's testimony before the Ways and Means Committee.

While Furman's testimony deals with a variety of critiques of the Bush administration tax cuts (some of which I agree with), one of the most dramatic claims he makes is that if the tax cuts were offset by reduced spending, the bottom 4 quintiles of the population would actually experience a reduction in income. This is a rhetorically powerful claim and is likely to become commonly cited in critiques of tax cuts. It also happens to be based on some very unrealistic assumptions which dramatically increase the negative income effects projected.

Table 3 from Furman's testimony (a copy of Matt Yglesias's copy I have posted here) details his projections broken down by quintile and separates out the top 1%. The change in income is determined by 3 factors - the Static Tax Cut consisting of direct reduction in taxes from the cuts, the Income Change, representing the expected change in income based on higher economic output due to lowered taxes, and a Finance Cost, dealing with the cost of offsetting the revenue reduction. And in this final factor (the sole source of negative income effects) lies the flaw in Furman's analysis.

Furman arrives at this number by assuming that every dollar cut from spending is a dollar reduced from someone's income received as a result of a transfer. Not only does this ignore the distinction between consumption and transfers that is made in the Treasury Department's analyses (as Furman admits in footnote 13) , it would require that all of the spending cut come from transfers (and none from obvious non-transfer items like military spending, administrative spending, foreign aid, etc) and that the transfers in question would have no overhead costs.

A more realistic assumption regarding how much the spending cut reduces transfers neutralizes Furman's claim. If transfers were reduced by 40% of the total spending cut (as would happen if half the cut were from transfers and the transfers had a 20% overhead on average - a far more realistic assumption than Furman's and still very charitable to his case, given the composition of the federal budget and the political difficulties of cutting transfers), every quartile except the bottom one experiences an increase in after tax income, including reduced transfers. This fits with the intuitive expectation that spending cuts that included transfers would free up more income for most people but would reduce the incomes of people at the bottom of the income distribution who utilize "safety net" programs and pay relatively little in taxes. This contrasts sharply with the narrative Furman and Yglesias are promoting, where the majority experiences a net income loss as a result of tax cuts offset by spending cuts.

The irony of this all is that Yglesias uses Furman's testimony as part of a series of posts haranguing conservatives willingness to use shoddy economic analysis to reach ideologically simpatico conclusions when buying into the myth that we are on the right side of the maximum of the Laffer Curve (more on how that particular illusion is constructed later).

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