The Tax-Cut Danger of “borrowing growth” (or, Laughing at Laffer)

"Although conventional estimates of the budgetary effect of tax policies incorporate a variety of behavioral effects, they are, nonetheless, based on a fixed economic baseline. For that reason, they do not include the budgetary impact of any possible macroeconomic effects of tax policies."

Douglas Holtz-Eakin, Director, Congressional Budget Office

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We last took a long hard look at Supply Side Economics way back in December 2003. More recently, a Congressional Budget Office report ("Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates") asked an intriguing question: 

"What are the economic impacts of tax cuts on subsequent revenues for governments?"

The NYTs Dan Altman opined: "it may be one of the most important government publications in years." I suspect he’s on to something.

Why? Most predictions about the impact of tax-rate changes fail to include "the budgetary impact of any possible macroeconomic effects of tax policies." They do not to account for how the tax cuts affect the overall size of the economy, and therefore influence future government tax revenues — and ultimately, deficits or surpluses. (I wonder what Soros would say about its reflexivity?)

Altman notes that "it is this omission – one often cited by proponents of tax cuts, especially in the White House – that the [CBO] paper tries to correct."

Here’s how the math shakes  out:

"The author of the analysis, Ben Page, estimates how an across-the-board cut in income tax rates could generate higher levels of economic activity, potentially replacing lost tax revenue. The theory behind these feedback effects is well worn: putting money back into taxpayers’ pockets will let them spend more and save more, raising demand for goods and services and helping companies to invest for the future.

Mr. Page assumes that government spending will continue as planned for a decade after the tax cuts. He also creates different possibilities based on various assumptions about people’s foresight, the mobility of capital and the ways in which the federal government might make up for the lost revenue when the decade is up – either by cutting spending or by raising taxes again. Finally, he compares the budget office’s figures to those of two private forecasting firms, Global Insight and Macroeconomic Advisers.

Like many predictions in economics, Mr. Page’s vary widely depending on his assumptions – this stuff is more like weather forecasting than Newtonian physics. But even within their range, the results answer the fundamental question posed by the Laffer Curve.

The recent analysis by Mr. Page at the Congressional Budget Office dismisses the idea that tax cuts may actually improve the government’s fiscal situation. Even in his most generous scenario, only 28 percent of lost tax revenue is recouped over a 10-year period. The United States, it seems, is firmly planted on the left side of the Laffer Curve. (emphasis added)

Note this is more than mere theory. Looking at the most recent tax cuts and their impact on revenues, we learn that recent experience corroborates this prediction:

"In the second quarter of 2001, just before the first of President Bush’s tax cuts took effect, federal receipts from personal taxes accounted for 10.3 percent of the economy. By the end of the post-recession slump, receipts had dropped to 6.4 percent. But in the third quarter of 2005, with the economy booming, they were still under 7.5 percent – an enormous difference. In dollar terms, federal receipts from personal income taxes, at $802 billion in 2004, are still lower than they were in 1998 ($826 billion) and much lower than in 2001 ($994 billion)."

The bad news may be even worse. Once a shortfall begins, the government does what governments always do — Borrow more:

"Shortfalls in revenue cause the government to borrow more, so money intended for other purposes must be paid as interest instead. Even in Mr. Page’s most generous picture, the federal government would probably have to pay an extra $200 billion in interest over the decade covered by his analysis."

What is the exact nature of the trade off? Mr. Page estimates that gross national product gains about 1% in exchange for higher deficits.

In other words, Supply Side Tax Cuts "borrow" growth.

This CBO thesis essentially challneges the entire premise of the Laffer Curve and Supply Side Economics. Former CEA Chair Gregg Mankiw (now back at Harvard) implied as much in his Macro Econ textbook. Expect to hear more about this in the coming year.

This study essentially confirms one of the oldest theories in all of Economics: There is no Free Lunch . . .

 

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With this post, we also add the category: "Taxes & Policy"

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Sources:
A Bit of Doodling About a Tax-Cut Danger
DANIEL ALTMAN
NYT,  January 1, 2006
http://www.nytimes.com/2006/01/01/business/yourmoney/01view.html

Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates Tax
A series of issue summaries from the
Congressional Budget Office DECEMBER 1, 2005
http://www.cbo.gov/ftpdocs/69xx/doc6908/12-01-10PercentTaxCut.pdf

Category: Economy, Politics, Taxes and Policy

Gold & The Wizard of Oz

Category: Commodities, Federal Reserve, Inflation

Death of Volatility

Category: Markets, Psychology, Technical Analysis, Trading

For 2006: Feedback, Please!

Category: Weblogs

Window Dressing

Category: Investing, Trading

P/E vs S&P 500 (50 Years)

As promised, today brings us to the 4th in our series of charts: P/E vs S&P500 click for larger chart courtesy of Mike Panzner, Rabo Securities > I’ll get into the significance of what this means to the markets later, but for now, note where the P/E is over the median, and its impact on…Read More

Category: Earnings, Markets, Psychology, Technical Analysis

Annual CD Sales Slide Resumes; Down 8% for ’05

We’ve broadly discussed the recording industry this year. How’d they do in terms of numbers?

Wsj_music_20051215
After a slight blip up in 2004, CD sales resumed their prior slide. Sales were off 7% (CD albums only) or 8% (CDs and singles). The decrease is comparable to the decline in Movie theater attendance, which fell about 7%.

Reported Album sales (January through the week ending
December 25) were 602.2 million in 2005; weaker than last year’s 650.8 million. Digital singles sales more than doubled to 332 million — a 148% increase.

Some blamed the Album CD sales slump on the cherry-picking of singles by a fickle public. But the broader analysis reveals that CDs are a format in decline. While 95% of music sales are still in the CD format, there are plenty of signs this is changing. In addition to the different fortunes of the two formats — CDs are slumping while digitial downloads skyrocket — the industry itself is changing. A new breed of music label is distributing their product strictly in digital format, thereby bypassing CDs entirely. See Cordless Recordings as an example of this.

This year’s biggest sellers, according to Nielsen SoundScan, were Mariah Carey’s Emancipation of Mimi at 4.866 million; In second place was 50 Cent’s The Massacre, which sold 4.834 million. "American Idol" winner Kelly Clarkson’s Breakaway finished 3rd, selling 3.4 million copies. The top sales position has not been occupied by a female solo artist since Alanis Morissette’s Jagged Little Pill in 1996. In 2005, female solo artists captured the gold and the bronze.

Although the major labels lament the internet, P2P, and file sharing, it turns out that the Net has been a boon for Indie Labels. Much of the industry’s complaints are actually about disintermediation — the web forces them out of the relationship between the artists and their fans. The indies understand this, and have been using the net to promote their unknown artists.   

While sales here, in the UK sales continue to do better than in the U.S. — despite Great Britain’s widespread adoption of broadband. Credit likely goes to the wider playlists in UK radio, and a payola-free radio industry. Britain does not have the same concentrated private ownership of Radio Stations which have become so prevalent in the U.S. since the 1996 Telecommunications Reform Act, which enabled firms like Clearchannel and Infinity to scoop up 1,000s of stations.

Its no coincidence that music sales problems can be traced to what occurred following that legislation’s enactment.

While legal Music downloads more than doubled this year, so too has the recording industry’s misconduct. After settling Price fixing charges in 2002, it appears that the recording industry brain trust is at it again: An industrywide probe into how much record companies charge for digital music was started by NYAG Eliot Spitzer; subpoenas have gone out to several labels.

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One last astonishing piece of music trivia: Mariah Carey’s CD spawned her 17th #1
single, "Don’t Forget About Us." This places her in second place on the
all time #1 hit list — behind the Beatles’ total 20 #1 hits. If Carey
manages to pass the Fab Four, I will interpret this as incontrovertible proof that life is meaningless or God is dead . . . I haven’t decided which.

Finally, you can see my Anti-"Best of 2005" here.

UPDATE January 3, 2006 6:09am

It turns out that the British are the ‘world’s biggest music buyers.’  According to figures released by the British Phonographic Industry (BPI) early 2005, the UK music industry recorded an overall 3% increase in volume sales, mostly due to its robust albums market.

The British buy the most compact discs in the world – an average of 3.2 per year, compared to 2.8 in the US and 2.1 in France.

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Sources:
Silent Night for Music Sales
Holiday Buyers Spurn Tunes As Industry Picture Worsens; ‘Cesspool of Really Bad Bands’
ETHAN SMITH
THE WALL STREET JOURNAL, December 16, 2005; Page B1
http://online.wsj.com/article/SB113469750280524159.html

UK ‘world’s biggest music buyer’
BBC, Tuesday, 22 March, 2005, 12:25 GMT
http://news.bbc.co.uk/1/hi/entertainment/music/4371673.stm

The extensive list of sources used in this posting can be found below

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Category: Music

A Different Kind of Music List: The Anti-”Best of 2005″

Category: Music

1966-1982 Trading Range

Here’s the 1966-1982 trading range: > click for larger chart chart courtesy of Rydex Funds > If we are in fact in a long, post-Bull trading range — see our 100-year Dow chart — than this is year ~5 of what could be a 10-15 year secular Bear market. As the 1966-82 trading range above…Read More

Category: Markets

2 Studies on the Flattening Yield Curve

Category: Federal Reserve, Fixed Income/Interest Rates, Inflation, Technical Analysis