TAXATION AND ECONOMIC GROWTH - Dartmouth College

SYMPOSIUM: WHAT CAN TAX REFORM DELIVER?

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TAXATION ANDECONOMIC GROWTHERIC ENGEN * &JONATHAN SKINNER **

Abstract - Tax reforms are sometimestouted as having strong macroeconomicgrowth effects. Using three approaches,we consider the impact of a major taxreform—a 5 percentage point cut inmarginal tax rates—on long-termgrowth rates. The first approach is toexamine the historical record of the U.S.economy to evaluate whether tax cutshave been associated with economicgrowth. The second is to consider theevidence on taxation and growth for alarge sample of countries. And finally,we use evidence from microlevel studiesof labor supply, investment demand,and productivity growth. Our resultssuggest modest effects, on the order of0.2 to 0.3 percentage point differencesin growth rates in response to a majortax reform. Nevertheless, even suchsmall effects can have a large cumula-tive impact on living standards.

INTRODUCTION

By now, a presidential campaign isincomplete without at least oneproposal for tax reform. Recent propos-als suggested that by reducing marginal

tax rates, or by replacing the currentfederal income tax with a consumption-type tax, the United States can experi-ence increased work effort, saving, andinvestment, resulting in faster economicgrowth. For example, Steve Forbesvaulted briefly into the political limelightbased almost solely on his advocacy of aflat tax which cut nearly every person’stax bill, but which was supposed tobalance the budget by stimulatingeconomic growth. The Kemp Commis-sion suggested that its general principlesfor tax reform would almost double U.S.economic growth rates over the nextfive to ten years.1 Most recently,presidential candidate Robert Doleproposed a 15 percent across-the-boardincome tax cut coupled with a halvingof the tax on capital gains, with apredicted increase in gross domesticproduct (GDP) growth rates from about2.5 to 3.5 percentage points.

Others have questioned whether taxreform would have such beneficialeffects on economic growth.2 If tax cutsfail to produce the projected boost ineconomic growth, tax revenues coulddecline, putting upward pressure on thedeficit, worsening levels of nationalsaving, and leading to laggard economicgrowth in the future. At this stage,however, there is little agreement about

*Federal Reserve Board, Washington, D.C. 20551.**Department of Economics, Dartmouth College, Hanover, NH

03755, and NBER, Cambridge, MA 02138.

NATIONAL TAX JOURNAL VOL. XLIX NO. 4

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Mozambique because its (per capita)capital stock is so much larger and moretechnologically advanced and itsworkers have more skills, or humancapital. The growth rate of economicoutput therefore will depend on thegrowth rate of these resources—physical capital and human capital—aswell as changes in the underlyingproductivity of these general inputs inthe economy. More formally, we candecompose the growth rate of theeconomy’s output into its differentcomponents:

where the real GDP growth rate incountry i is denoted yi and the netinvestment rate (expressed as a fractionof GDP), equivalently the change overtime in the capital stock, is given by ki .The percentage growth rate in theeffective labor force over time is writtenmi, while the variable µi measures theeconomy’s overall productivity growth.

There are two other relevant variables inequation 1, which are the coefficientsmeasuring the marginal productivity ofcapital, αi, and the output elasticity oflabor, βi.

3 For example, if there were aone percentage point increase in thegrowth rate of the (skill-adjusted) laborforce and β were equal to 0.75, theimplied increase in the economic growthrate would be 0.75 percentage point.Alternatively, if the investment rate wereto rise by one percentage point and αwere 0.10, the growth rate of outputwould rise by 0.10 percentage point.

This theoretical framework allows us tocatalog the five ways that taxes mightaffect output growth, corresponding toeach of the variables on the right-handside of equation 1. First, higher taxes

whether a major tax reform wouldprovide an economic boon to the UnitedStates or impede economic growth.

In this paper, we reexamine the relation-ship between economic growth andtaxation in light of the accumulatedeconomic evidence, both from theUnited States and other countries. Whilemany economists would agree with theproposition that “high taxes are bad foreconomic growth,” we show that thisproposition is not necessarily obvious,either in theory or in the data. However,we find that the evidence is consistentwith lower taxes having modest positiveeffects on economic growth. While suchgrowth effects are highly unlikely toallow tax cuts to pay for themselves,they can contribute to substantialdifferences in the level of economicactivity and living standards, particularlyover the long term.

SHOULD WE EXPECT TAXES TOAFFECT GROWTH? A THEORETICAL

Before jumping into the morass ofempirical evidence, it is useful to firstask the question: How does tax policyaffect economic growth? By discourag-ing new investment and entrepreneurialincentives? By distorting investmentdecisions because the tax code makessome forms of investment moreprofitable than others? Or by discourag-ing work effort and workers’ acquisitionof skills? These questions are oftenaddressed in an accounting frameworkfirst developed by Solow (1956). In thisapproach, the output, y, of an economy,typically measured by GDP, is deter-mined by its economic resources—thesize and skill of its workforce, m, andthe size and technological productivityof its capital stock, k. Thus, a countrylike the United States might be expectedto have a greater per capita output than

1

.

y i = α ik i + βim i + µ i

. . .

.

.PERSPECTIVE


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1

2

1

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can discourage the investment rate, orthe net growth in the capital stock (ki inequation 1 above), through highstatutory tax rates on corporate andindividual income, high effective capitalgains tax rates, and low depreciationallowances. Second, taxes may attenu-ate labor supply growth mi by discour-aging labor force participation or hoursof work, or by distorting occupationalchoice or the acquisition of education,skills, and training. Third, tax policy hasthe potential to discourage productivitygrowth µ by attenuating research anddevelopment (R&D) and the develop-ment of venture capital for “high-tech”industries, activities whose spillovereffects can potentially enhance theproductivity of existing labor and capital.

Fourth, tax policy can also influence themarginal productivity of capital bydistorting investment from heavily taxedsectors into more lightly taxed sectorswith lower overall productivity

(Harberger, 1962, 1966). And fifth,heavy taxation on labor supply candistort the efficient use of human capitalby discouraging workers from employ-ment in sectors with high social produc-tivity but a heavy tax burden. In otherwords, highly taxed countries mayexperience lower values of α and β,which will tend to retard economicgrowth, holding constant investmentrates in both human and physical capital(Engen and Skinner, 1992). We showthis graphically in Figure 1, whichfocuses on a fixed level of the capitalstock K, shown by the width of thehorizontal axis. (A similar analysis holdsfor labor market distortions.) Supposethat the income tax on the corporatesector, as well as subsidies to non-corporate owner-occupied housing,distort the allocation of the capital stockbetween the corporate (c) and non-corporate (nc) sectors. (In other coun-tries, the distortion may arise betweensectors which escape taxation such as

.

.

FIGURE 1. The Effect of Intersectoral Distortions on the Average Rate of Return


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the underground economy or small-scale agriculture, versus the manufactur-ing sector which is easily taxed orheavily regulated.) The line denotedMP(c) is the value of the marginalproduct of capital in the corporatesector, while MP(nc) denotes the valueof the marginal pro-duct in thenoncorporate sector. Without any taxdistortion, the profit-maximizing andmost efficient point is C; the mar-ginalproductivity of capital is equalized inboth sectors and the economy-widereturn on capital is R*, as shown by thedotted line. (The allocation of the totalcapital stock, K, is Q* units of capital inthe noncorporate sector and K-Q* unitsin the corporate sector.) With a tax ofAB on corporate capital only, there is adistortion in the allocation of capital;capital flows from the corporate to thenoncorporate sector, so the newallocation is Q units of capital in thenoncorporate sector and K-Q units ofcapital in the corporate sector. The netloss in output is given by ABC, thetraditional Harberger welfare losstriangle. Under some plausible restric-tions, the average rate of return for theentire capital stock, R, will correspond tothe rate of return on new investment,given in equation 1 by α.4 Hence, adistortionary tax on capital (or on labor)will be reflected in lower overall rates ofreturn on new investment (from R* toR), leading to laggard growth rates.

We have outlined five possible mecha-nisms by which taxes can affect eco-nomic growth. Therefore, it mightappear that taxes should play a centralrole in determining long-term growth.However, the conventional Solow growthmodel implies that taxes should have noimpact on long-term growth rates. Inpart, this result occurs by assumption,since productivity growth µ is assumedto be fixed and unaffected by tax policy.But this paradoxical result holds also

because of a distinction betweenchanges in the level of GDP and changes ingrowth rates of GDP. For example,suppose that, in the year 2000, a “taxand spend” president is elected in theUnited States and tax rates are increasedby ten percentage points across theboard. (Ignore the effects of the extragovernment spending on the economy.)The extra tax distortion reduces laborsupply and investment, causing asudden decline in short-term growthrates. But once the U.S. economy hadadjusted to the harsh new tax regime, itwould revert back to its original growthpath, albeit at a lower absolute levelthan it would have been in the absenceof the tax hikes. (In the Solow model,both investment and labor supplygrowth revert back to their original ratesdetermined by long-term populationgrowth.) In other words, the simpleSolow model implies that tax policy,however distortionary, has no impact onlong-term economic growth rates, evenif it does reduce the level of economicoutput in the long-term.

So then how can taxation affect outputgrowth rates? We focus on two possiblemechanisms. The first is that when thestructure of taxes changes, short-termoutput growth rates would be expectedto change as well along a possiblylengthy transition path to the newsteady state. If one believes that theDole or the Forbes tax reform wouldexpand output by five percentage pointsand it takes ten years to make thetransition to the new steady state,growth rates will be higher, on average,by about 0.5 percentage points duringthis period before settling back down totheir long-run values.5 Ten years is along-term horizon for presidentialcandidates but is still the short-term inthe Solow model. And these short-termeffects are clearly important, since theyresult in a permanent increase in GDP.


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The second possibility arises within thecontext of the new class of “endog-enous growth” models (e.g., Romer,1986; Lucas, 1990). In these models,the stable growth rate of the Solowmodel, stapled down by technology andworkforce productivity growth, isreplaced by steady-state growth rateswhich can differ, persistently, because oftax and expenditure policies pursued bythe government (e.g., King and Rebelo,1990). The endogenous growthframework emphasizes factors such as“spillover” effects and “learning bydoing,” by which firm-specific decisionsto invest in capital or in R&D, orindividual investments in human capital,can yield positive external effects(e.g.,on µ ) that benefit the rest of theeconomy. In these models, taxes canthen have long-term, persistent effectson output growth. However, thequestion still remains: what is themagnitude of these tax effects oneconomic growth?

A number of recent theoretical studieshave used endogenous growth modelsto simulate the effects of a fundamentaltax reform on economic growth.6 All ofthese studies conclude that reducing thedistorting effects of the current taxstructure would permanently increaseeconomic growth. Unfortunately, themagnitude of the increase in economicgrowth is highly sensitive to certainassumptions embodied in the economicmodels used in these studies, with littleempirical guidance or consensus aboutkey parameter values. Consequently,these studies reached substantiallydifferent conclusions concerning themagnitude of the boost in growth rates.At one extreme, Lucas (1990) calculatedthat a revenue-neutral change thateliminated all capital income taxes whileraising labor income taxes wouldincrease growth rates negligibly. At theother extreme, Jones, Manuelli, and

Rossi (1993) calculated that eliminatingall distorting taxes would raise averageannual growth rates by a whopping fourto eight percentage points.7 (An“across-the-board” reduction indistortionary tax rates in these models,rather than complete elimination ofdistortionary taxes, would be expectedto have a smaller positive effect oneconomic growth.) Most recently, thesimulation model in Mendoza, Razin,and Tesar (1994) suggests relativelymodest differences in economic growthof roughly 0.25 percentage pointsannually as the consequence of a 10percentage point change in tax rates.

These simulation models of endogenousgrowth fail to provide a comfortablerange of plausible effects of taxes ongrowth and thus tend to raise morequestions than they answer. Moreover,they are likely to miss many relevantcharacteristics of the U.S. tax system. Nomacroeconomic model allows for thepossibility of a firm undertakingfinancial restructuring to reduce taxableincome, or of timing issues in deferredtaxes, or the possibility of tax evasion.8

Often the simulation analysis is per-formed in terms of a single flat-rate taxin the context of a (single) representa-tive agent model. Ultimately, one needsto consider the empirical record to makeinformed judgments about whether taxpolicy exerts a strong influence oneconomic growth.

Below, we take three separate ap-proaches to judge the empirical record.First, we take a quick look at the U.S.historical record to see if there is aneasily discernible link between changesin U.S. tax policy and changes ineconomic growth across time. Second,we consider whether differences ingrowth rates across countries can beattributed, at least partially, to variationin tax policy. Third and finally, we survey


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the microlevel studies of how taxesaffect specific subsectors of theeconomy and build up from thesemicrolevel studies to make inferencesabout aggregate tax effects.

AN INFORMAL LOOK AT TAXES AND U.S.ECONOMIC GROWTH

Anecdotal stories about the U.S. taxcode can sometimes have a largerimpact on the policy debate than astack of statistical studies. The KempCommission (NCR, 1996), for example,highlighted the complaint of onefrustrated businessman:

As an entrepreneur, I experience first handthe horrors of our tax system. It has growninto a monstrous predator that kills in-centives, swallows time, and chokes thehopes and dreams of many. We haveabandoned several job-creating businessconcepts due to the tax complexities thatwould arise.

While this testimony is suggestive thatthe tax system adversely affects incen-tives, it is not entirely clear whether theentrepreneur is concerned about the taxrate per se or the complexity of the taxsystem more generally. And we are notsure what fraction of entrepreneurs areof like mind, or how much investment isaffected adversely by the tax code. Forexample, surveys from a few decadesago indicate that typical businesspeopledid not view taxes as an impediment tobusiness decisions; in one study con-ducted in Britain in the early 1960s, nota single executive out of the sample of181 replied that they abandoned theintroduction of a new plant or equip-ment during the past seven yearsbecause of tax changes (Corner andWilliams, 1965).9 More recent surveystudies suggest a larger impact oftaxation on the discount rates used toevaluate private investment projects(Poterba and Summers, 1995); even

among these tax-savvy Fortune 1000executives, 36 percent reported that acorporate tax cut from 34 to 25 percentwould not make them more likely toengage in investment projects.10

A slightly more rigorous approach is tolook at the historical evidence fromtime-series changes in taxation andoutput growth. The Kemp Commission’sreport (NCR, 1996) relied on time-seriescomparisons to argue that the patternsare self-evident:

America has experienced three periods ofvery strong economic growth in this cen-tury: the 1920s, the 1960s, and the1980s. Each of these growth spurts co-incided with a period of reductions inmarginal tax rates. In the eight years fol-lowing the Harding–Coolidge tax cuts,the American economy grew by morethan five percent per year. Following theKennedy tax cuts in the early 1960s, theeconomy grew by nearly five percent peryear. . . In the seven years following the1981 Reagan tax cuts, the economy grewby nearly four percent per year while realfederal revenues rose by 26 percent.

This approach does not try to performthe “growth accounting” exercisedetailed in the theoretical section, butasks simply whether there are discern-ible differences in GDP growth followingtax cuts. We consider the latter two taxreforms in Figure 2, which shows realGDP growth rates (both total and percapita) in the United States between1959 and 1994 in the bottom panel,with the relevant tax series graphed inthe upper two panels.11 To smooth outyear-to-year volatility in GDP growthrates, we present three-year movingaverages of GDP growth rates in thebottom panel of Figure 2, both foraggregate growth rates and for percapita growth rates. The two economicexpansions noted above during the1960s and the 1980s are apparent, as


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FIGURE 2. Average Tax Rates, Marginal Tax Rates, and GDP Growth in the United States, 1959–95


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are the other expansions followingrecessions (shown by the shadedregions). The general slowdown ineconomic growth over the last threedecades can be seen also.

Moving to the top panel of Figure 2, wenext consider the ratio of tax revenue toGDP—a commonly used measure of theaverage tax burden. The top line showsU.S. federal government revenue(measured on a National Income andProduct Accounts (NIPA) basis) as apercentage of GDP. The lower line isstate and local government tax revenuemeasured on a NIPA basis as a percent-age of GDP. Since 1959, the averagefederal tax rate has risen by about twopercentage points, but has generallyhovered around 20 percent of GDP; theaverage individual income tax rate hasremained relatively constant, whilegrowth in social insurance taxes havebeen mostly offset by the decline incorporate and excise taxes. State andlocal government average tax burdenshave risen by about three percentagepoints over the last three decades.

The Kennedy–Johnson tax cuts in 1964resulted in a small decline in the averagetax rate. Real GDP growth averaged arobust 4.8 percent over the subsequent1964 to 1969 period. However, theextent to which this growth was causedby the tax cuts is unclear, as GDPgrowth had averaged over five percentin the two years prior to 1964.

The Reagan tax cuts also lowered theaverage tax rate, and real GDP growthaveraged a healthy 3.9 percent from1983 to 1989, significantly above thepreceding period from 1980 to 1982that was dominated by recession.12 Butit is a difficult task to sort out whetherthe strong growth during the 1980s wasthe consequence of supply-side effects

of lowering marginal tax rates, tradi-tional Keynesian aggregate demandeffects fueled by tax cuts and expandingdefense expenditures, or a recovery thatwould have occurred without the taxchange.13 Indeed, Feldstein andElmendorf (1989) suggest a somewhatdifferent cause for the 1980s expansion:expansionary monetary policy combinedwith a strong dollar and active businessinvestment.

Over the longer term, since 1959, boththe average federal tax rate and theaverage state-local tax rate have risen—by about two and three percentagepoints, respectively. At the same time,average growth rates in real GDP havedeclined, from 4.4 percent during the1960s to only 2.4 percent in 1986–95.These coincident trends over the lastthree and a half decades are consistentwith the hypothesis that higher taxeshave stunted economic growth. Beforearriving at conclusions about taxationand growth from this single observation(which does not account for otherfactors that were also changing over thistime period), we note that the averagetax rate series is unlikely to reflect themarginal tax distortion, which economictheory suggests is more important inaffecting economic growth throughhouseholds’ and firms’ choices ofsaving, investment, and employment.

The middle panel of Figure 2 shows themarginal individual income tax ratesrelevant for households at the 75th,50th, and 25th percentiles of theincome distribution in each year(Hakkio, Rush, and Schmidt, 1996).14

From 1960 to the early 1980s, marginaltax rates at the 75th percentile grewwhile marginal tax rates at the 25thpercentile declined slightly. There wassome reduction in output growthcoincident with the increase in the


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upper-middle class marginal tax rates.However, GDP growth rates continuedto fall over the past decade even as themarginal tax rates for both upper- andlower-income households declined.15 Inother words, the time-series correlationbetween marginal tax rates and growthrates yields a decidedly mixed picture;some decades were correlated positively,and others negatively.

Finally, we correct the first sentence ofthe quotation from the Kemp Commis-sion above. The most rapid growth ratesin this century were, in fact, during theperiod 1940–45, when output grew at12.5 percentage points annually. Duringthis same period, the federal tax systemexpanded dramatically, with medianmarginal tax rates rising from 3.6percent in 1940 to 25 percent in 1945.Yet it would be ludicrous to claim onthat basis that higher taxes have apositive effect on output growth, giventhe obvious confounding events duringthis period. Nevertheless, highlightingthe period 1940–45 is useful for twopurposes. The first is that it illustratesthe risks of trying to discern incentiveeffects of taxation using short-termtime-series data. This is a point rein-forced by the experience of Sweden’stax reform, when the economy fell intoa recession just after a tax reformtrimming marginal tax rates substantially(Agell, Englund, and Sodersten, 1996).And second, it suggests that one shouldlook most carefully at GDP growth ratesbefore and after the early 1940s whenthe federal income tax experienced itsmajor expansion. Stokey and Rebelo(1995) looked for this break in long-term output growth rates and wereunable to find any significant difference.On the other hand, given the majordisruptions in economic activity occur-ring during the 20th century, it may beasking too much of the data to detect

what might be very small differences ingrowth rates, on the order of 0.5 per-centage points, caused by thedistortionary effects of taxation.

More formal econometric methods mayhold greater promise for uncovering thepure effects of taxation on economicgrowth, because that type of analysisattempts to control for other factorsthat affect output independently of taxpolicy. The problem is that time-seriesanalysis is best suited for detectingshort-term effects of changes in taxpolicy on output growth, which, asnoted above, may reflect Keynesianexpansionary effects of deficit spendingor other unmeasured factors associatedwith tax cuts. In addition, figuring outwhich characteristics of a particular taxreform—changes in top marginal taxrates, depreciation allowances, taxprogressivity, tax rates on capital gains—caused changes in growth rates isparticularly problematic in aggregatetime-series analysis. For these reasons,we turn our attention next to cross-country studies.

TAX POLICY AND GROWTH: THE CROSS-COUNTRY EVIDENCE

An alternative empirical approach is todraw on the experience of differentcountries to investigate how tax policyaffects economic growth. Countrieshave very different philosophies abouttaxation and very different methods ofcollecting their revenue. During the pastseveral decades, some countries haveincreased taxation quite dramatically,while, in other countries, tax rates haveremained roughly the same. Somecountries incorporated value-addedtaxation in the 1960s (e.g., France andBritain), while others shifted away fromcorporate taxation (the United States).The advantage of using such cross-


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country comparisons is that we can usemany countries with different taxstructures and GDP growth rates to testfor correlation (and, one hopes, causa-tion) between tax policy and growth.

In general, studies of taxation usingcross-country data suggest that highertaxes have a negative impact on outputgrowth, although these results are notalways robust to the tax measure used.Using reduced-form cross-sectionregressions, Koester and Kormendi(1989) estimated that the marginal taxrate—conditional on fixed average taxrates—has an independent, negativeeffect on output growth rates. Skinner(1988) used data from African countriesto conclude that income, corporate, andimport taxation led to greater reductionsin output growth than average exportand sales taxation. Dowrick (1992) alsofound a strong negative effect ofpersonal income taxation, but no impactof corporate taxes, on output growth ina sample of Organisation for EconomicCo-operation and Development (OECD)countries between 1960 and 1985.Easterly and Rebelo (1993) found somemeasures of the tax distortion (such asan imputed measure of marginal taxrates) to be correlated negatively withoutput growth, although other mea-sures of the tax distortion were insignifi-cant in the growth equations.

Most empirical studies of taxation andgrowth are “reduced form” estimates inthat they specify a linear model ofoutput growth rates, with tax rates,labor resource growth, and investmentrates on the right-hand side of theequation. However, taxes do notnecessarily enter the growth accountingframework in equation 1 in a linearfashion. We explored this possibility inEngen and Skinner (1992), where theprimary growth effect of tax distortionson production is hypothesized to

depress the economy-wide return oncapital, α, and on labor, β (as inequation 1 and Figure 1). Using cross-country data for 1970–85, Engen andSkinner found that an increase of 2.5percentage points in the average taxburden (total taxes divided by GDP) ispredicted to reduce long-term outputgrowth rates by 0.18 percentage points,holding constant the supply of invest-ment and labor.

A recent McKinsey (1996) study pointsto the potential importance of theintersectoral allocation of capital. Thestudy observed that Japan and Germanyboth had much higher rates of invest-ment. But because U.S. investmentappeared to be allocated to moreprofitable (i.e., higher productivity)sectors, the net increment to theeffective capital stock, and hence tonational income, was considerablygreater in the United States, despite thelower investment rate. Similarly, Kingand Fullerton (1984), in their study oftax systems in the United Kingdom,Sweden, West Germany, and the UnitedStates, found a strong negative correla-tion between economic growth and theintersectoral variability in investment taxrates.16

Of course, nearly any tax will tend todistort economic behavior along somemargin, so the objective of a well-designed tax system is to avoid highlydistortionary taxes and raise revenuefrom the less distortionary ones. There issome evidence that how a countrycollects taxes matters for economicgrowth. Figure 3, reproduced fromMendoza, Milesi-Ferretti, and Asea(1996), shows the correlation amongthe OECD countries between incometaxes and economic growth (panels Aand B) and consumption taxes andeconomic growth (panel C), over theperiod from 1965 to 1991. These scatter


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plots, largely confirmed in regressionanalysis, suggest that income taxation ismore harmful to growth than broad-based consumption taxes.

It is useful to consider the growtheffects of a major tax reform using thesecross-country regression estimates.Suppose that marginal tax rates are cutby a uniform five percentage points andaverage tax rates are cut by 2.5 percentof GDP, leading to a (static) revenue lossof $185 billion annually. This hypotheti-cal tax reform was chosen because it ison the outer fringe of politically feasibletax reform, losing more than twice asmuch revenue as the tax proposalsupported by presidential candidateRobert Dole. Were such a plan enacted,the tax-to-GDP ratio would revert tolevels last seen in 1958. As noted above,the estimated coefficient from Engenand Skinner (1992) that ignores possiblechanges in the supply of capital andlabor implies an increase in long-term

growth rates of 0.18 percentage points.Including estimates of the responsive-ness of investment to the marginal taxrate from Mendoza, Milesi-Ferretti, andAsea (1996) suggests that this hypo-thetical tax reduction would increaseinvestment by 1.35 percent, boostingthe predicted growth rate effect of thetax cut to 0.32 percentage pointsannually.17

SANDTRAPS IN CROSS-COUNTRYECONOMETRIC ANALYSIS

To this point, we have been taking theresults of the cross-country econometricstudies at face value. Any empiricalstudy must be treated with somecaution; but, in many of the studiescited above, particularly the cross-country studies, one must be particularlycareful in the interpretation of thecoefficients (Levine and Renelt, 1992;Slemrod, 1995). We consider justfour of these potential problems below.

FIGURE 3A. Growth and the Capital Income Tax, OECD Countries


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FIGURE 3B. Growth and the Labor Income Tax, OECD Countries

FIGURE 3C. Growth and the Consumption Tax, OECD Countries


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First, studies of taxation and growthmay find negative growth effectsresulting from taxation, but it is moredifficult to measure the potentialbenefits of the spending financed by therevenue collected. The combined impactof distortionary taxes and beneficialgovernment expenditures may yield anet improvement in the workings of theprivate sector economy (e.g., Barro,1990, 1991a,b). An example of thedeleterious effects caused by theabsence of government spending comesfrom the World Development Report(World Bank, 1988, p.144):

According to the Nigerian Industrial De-velopment Bank (NIDB), frequent poweroutages and fluctuations in voltage af-fect almost every industrial enterprisein the country. To avoid productionlosses as well as damage to machineryand equipment, firms invest in genera-tors.. . . One large textile manufacturingenterprise estimates the depreciated capi-tal value of its electricity supply invest-ment as $400 per worker.. . . Typically, asmuch as 20 percent of the initial capitalinvestment for new plants financed by theNIDB is spent on electric generators andboreholes.

That is, when the government of Nigeriadid not provide the necessary electricitysupply, private firms were forced togenerate electricity on their own, andpresumably at much higher cost. Clearly,a tax in Nigeria earmarked for (new)government expenditures on improvingthe electrical system would be likely toenhance economic growth even if thetaxes distorted economic activity. Theproblem is that taxes are not necessarilyearmarked to those expenditures mostconducive to economic growth, eitherbecause of political “inefficiencies” orbecause of redistributional policies thatmay yield benefits for society but willnot be reflected in robust GDP growthrates (Atkinson, 1995).18 Thus, one

must be careful in interpreting thecoefficients on tax and output growthstudies to remember that these esti-mates reflect just one part—the costs—of a combined tax and expendituresystem.

Second, one should be very wary of thedata, particularly from developingcountries with large agricultural orinformal sectors where the measure-ment of income is difficult indeed.19

Even in developed countries, it is wellknown that GDP measures suffer frombiases and mismeasurement of produc-tivity in service sectors, for example.20

Measuring “the” effective tax rate iseven more difficult, given the widevariety of tax distortions, methodsfor measuring them, and variationacross countries in administrativepractices.

Third, there are real difficulties withreverse causation; one does not knowwhether regression coefficients reflectthe impact of investment on GDPgrowth rates, for example, or thereverse influence of GDP growth rateson investment, or both effects com-bined (Blomstrom, Lipsey, and Zejan,1996). Sometimes these biases creep inbecause of the way the regressionvariables are constructed. Suppose onewanted to estimate an explicitly short-term relationship between the change inthe tax burden, typically measured asthe ratio of tax revenue to GDP, and thepercentage growth rate in GDP. Anypositive measurement error (or short-term shock) in GDP will shift GDPgrowth rates up but also tend to shiftthe tax-to-GDP ratio down, therebyintroducing a spurious negative bias inthe estimated coefficient.21 One can tryto avoid such bias by introducing asexplanatory variables the percentagegrowth rate in the level of taxation, orof government expenditures, rather


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than the change in the ratio, as above.In this case, the bias would go in theopposite direction, because countriesthat grow rapidly also tend to experi-ence rapid growth in tax collection andin spending.22 One approach for both ofthese problems is to use instrumentalvariables for changes in governmentspending and taxation (Engen andSkinner, 1992), although the problemstill remains to find appropriate exog-enous instruments.

Another “reverse causality” problemcomes in deciding what factors toinclude on the right-hand side of agrowth regression. Should one controlfor other factors such as inflation,political unrest, and the share ofagriculture in total output? On the onehand, these are factors that could bespuriously correlated with tax policy, andone would clearly want to control forthem. But, on the other hand, ashrinking share of agriculture in output,or political unrest, or inflation could besymptomatic of the underlying growthrate of the economy. During severerecessions, countries often resort to highinflation rates as a means of financingexpenditures after their tax collectionefforts have collapsed. This reversecausation makes it harder to argue thatinflation “causes” poor economicgrowth, as well as making it difficult tointerpret the coefficients on all othervariables. In sum, reverse causality isreally the Achilles’ heel of the typicalcross-country regression. Nearly everyvariable on the right-hand side of theregression is suspect.

Fourth, as noted by Slemrod (1995),countries may differ both in their tastesfor government-sector spending (thedemand side) and in their ability to raisetax revenue (the supply side). Supposethat more developed countries experi-ence a lower cost of raising tax revenue,

perhaps because industrial production ismuch easier to tax than agriculturalproduction. Then countries that growquickly may also experience a morepronounced drop in their cost of raisingtax revenue, which could in turn lead tomore rapid growth in tax revenue. Theresearcher might well find a spuriouspositive correlation between tax ratesand output growth. By the same token,countries that grow fast may exercise agreater taste for government spending(sometimes known as Wagner’s law),leading to a shift to the right in thedemand for government spending. AsSlemrod points out, such a model wouldimply that, in a cross section of coun-tries, there could be little correlationbetween output growth, governmentspending, and taxation.23 Slemrod’spoint is therefore a cautionary one, thatthe regression coefficients one actuallyestimates may have little to do with theSolow-style production function writtenin equation 1 (see also Islam, 1995). Butthis point also suggests that, even iftaxes affect growth rates adversely,cross-country regression models wouldbe biased against detecting such effects.

SECTORAL STUDIES OF TAXATION ANDGROWTH

Our third approach is to considerseparately the effect of taxes on thedisaggregated “micro” components inequation 1, such as labor supply, humancapital, investment, and technologicalgrowth. We then combine these effectsto arrive at an aggegrate “bottom-up”measure of how our hypothetical taxreform—cutting marginal tax rates byfive percentage points, and averagerates by 2.5 percent—will affect outputgrowth.24 The advantage of thisapproach is a more accurate measure ofhow economic agents respond to taxincentives, often with data generated bynatural experiments such as tax reform


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or other (exogenous) legislative change.There are two disadvantages to thisstrategy, however. First, we are unableto account for the spillover effects ofboth human and physical capitalaccumulation, as in the hypothesizedcorrelation between the level ofinvestment and technological innovation(Boskin, 1988). And, second, even withthis disaggregated approach, there isvirtually no empirical evidence on somekey parameter values.

Change in the Labor Force

Consider first the effects of taxation onlabor supply. The top panel of Figure 4contains a graph that shows marginallabor income tax rates for the UnitedStates from 1965 to 1988 fromMendoza, Razin, and Tesar (1994)plotted against the average weeklyhours for workers in private nonagricul-tural industries and also the civilianlabor force participation rate. As laborincome tax rates have increased,average weekly hours have declined. Onthe other hand, labor force participationhas increased. (Although not shown,participation has generally increased forwomen while falling for men.) Thus, theeffect of increased marginal labor taxesappears to be ambiguous based on thissimple time-series examination.

A voluminous empirical literature hasexamined how taxes affect the laborsupply of individuals within variousdemographic groups (e.g.,Killingsworth, 1983; Hausman, 1985;MaCurdy, Green, and Paarsch, 1990;Triest, 1990, 1996; Bosworth andBurtless, 1992; Mariger, 1995; Eissa,1996a,b). Generally, the results suggestquite modest labor supply effects of taxpolicy in the United States.25 Mostestimates suggest that both work hoursand labor force participation for menare only mildly responsive to historically

experienced tax changes, and Heckman(1993) concludes that most of theevidence points to a relatively largerparticipation effect than hours effect.Estimated uncompensated tax elastici-ties are usually small, often in the rangeof zero to 0.1.26 Recently, Eissa (1995)found that married women in high-income households are more responsiveto tax changes—with tax elasticities inthe range of 0.6 to 1—with approxi-mately equal importance on hours andparticipation changes. However,working married women make up arelatively small part of the labor forceand often have relatively tenuous ties tothe labor force (Eissa, 1996a). Like men,unmarried women generally havesimilarly small labor supply responses totaxes (Eissa, 1996a).

For the purposes of our equation 1, wewould like to know how tax policyaffects the rate of change in quality-adjusted labor supply m. Consider firstshort-term effects. If the labor supplyelasticity is assumed to be 0.15 andmarginal tax rates decline by fivepercentage points, then one mightexpect an increase of 0.75 percent intotal hours worked. Assuming laborincome comprises 75 percent of totaloutput and the labor market transitionis spread over a ten-year transitionperiod, the net change in GDP growthrates over the short-term (ten-year)period would be 0.06 percent annually.In the long-term, however, only tax-induced changes in the accumulationof education or human capital moregenerally would affect the growthrate m.

A number of empirical studies (e.g.Romer, 1990; Mankiw, Romer, and Weil,1992; Judson, 1996) suggest thatmeasures of human capital havestatistically and economically importanteffects on economic growth, although

.

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FIGURE 4. Labor, Investment, and Factor Tax Rates, 1965–88


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some (e.g., Barro and Lee, 1992)estimate that the effect is quite small.However, the effect of taxes on humancapital formation is quite uncertain.Theoretically, the effect is ambiguousand, not surprisingly, simulation analysiscan lead to a variety of conclusions.Trostel (1993) simulates substantiallong-term elasticities of human capitalwith respect to taxation; he suggests along-term increase in human capital of0.97 percent per one percentage pointdecrease in the marginal tax rate.Hence, our hypothetical five percentagepoint reduction in the marginal tax ratewould be predicted to increase the stockof human capital by 4.8 percent. Inequilibrium, maintaining that higherlevel of human capital requires an extra4.8 percent additional net investment inhuman capital. Suppose that mi wereabout three percent annually. The newlevel of equilibrium growth in humancapital would rise to 3 × 1.048, or 3.14percent annually.27 Assuming the factorshare coefficient is 0.75, the net effect ongrowth would be 0.10 percentage points.

Change in the Net Investment Rate

The bottom panel of Figure 4 showsmarginal capital income tax rates for theUnited States from 1965 to 1988 fromMendoza, Razin, and Tesar (1994),plotted against private nonresidentialfixed investment as a percentage of GDP.As has been noted before (e.g.,Chirinko, 1993; Hassett and Hubbard,1996), a simple examination of the time-series evidence suggests little relation-ship (and possibly a positive correlation)between investment and capital incometax rates. However, as before, this typeof analysis is surely too simplistic.

Alternatively, Figure 5 shows a graphfrom data on the OECD countriescomparing capital income taxes withinvestment rates, taken from Mendoza,

Milesi-Ferretti, and Asea (1996). There isa moderate negative correlationbetween tax rates and investment rates;more detailed regression analysissuggests that a 10 percentage pointchange in tax rates on profits couldaffect investment rates by at most twopercentage points. It should be noted,however, that one shortcoming of thesecapital tax measures is that they useweighted statutory rather than effectiverates, and thus they cannot account forthe dramatic increase in effectivemarginal tax rates on capital duringperiods of inflation (e.g., King andFullerton, 1984; Fullerton andKarayannis, 1993).

A number of recent studies (e.g.,Auerbach and Hassett, 1991; Cummins,Hassett, and Hubbard, 1994, 1996;Chirinko, Fazzari, and Meyer, 1996)have found significant effects of taxpolicy on investment, suggesting aplausible range for the investmentelasticity for changes in the user cost ofcapital in the range of 0.25 to 1. Thisfinding is potentially important because,although Levine and Renelt (1992) findthat almost all results are fragile incross-country growth regressions, theydo find a positive, robust correlationbetween growth and investment.

How might a change in the nature ofinvestment decisions affect outputgrowth? Suppose we adopt an invest-ment elasticity of 0.5; then, a fivepercentage point drop in marginal taxrates should boost investment rates by2.5 percent, or by about 0.4 percent ofGDP. Assuming the net marginalproduct of capital is ten percent, outputgrowth rates might be expected to growby another 0.04 percentage points. Weassume this boost in growth rate will bepermanent, although in the Solow-stylemodel, the growth effects will diminishover time.

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One factor that could stifle tax-inducedinvestment expansions is a lack of newsaving to finance the increased invest-ment. In an economy without foreigncapital flows, the increased demand forinvestment would be financed by theadditional supply of saving attracted byhigher net interest rates. But simulationmodels (Engen, 1996) and empiricalstudies (Skinner and Feenberg, 1990)find little support for a strong respon-siveness of personal saving to theinterest rate (although, see Elmendorf,1995, and references cited therein). Therelevant source of financing for theextra investment may therefore beretained earnings of firms and foreigninvestors.28 In any case, the investmentelasticities gained from microlevelstudies of firm investment behavioralready reflect the additional cost ordifficulty incurred by firms in providingadditional financing for their invest-ments, suggesting that the puredemand elasticities are even larger.

The Impact of Taxation on theProductivity Residual

Taxes can affect the output growth inanother way, by discouraging innova-tions and economic organizations thatresult in increased levels of output,holding constant the supply of capitaland labor. In other words, distortionarytax policy may permanently reduce thelevel of technological growth µ. Ofcourse, by its nature, trying to determinewhether the residual effect µ is causedby tax policy or by some other factor (ofwhich there are always many candi-dates) is always problematic. Here, weconsider two examples: the effects oftax policy on research and developmentand its impact on entrepreneurship.

Hall (1993) studied the impact of the taxcredit on R&D spending using twosources of variation: changes in the taxcode over the 1980s and differences inthe taxable status of individual firms

FIGURE 5. Capital Income Taxation and Investment Rates, OECD Countries


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that affected their ability to takeadvantage of the credits. She foundquite large effects: for every $1 billionlost in tax revenue, there was a $2billion increase in R&D spending. SinceR&D is about 2.5 percent of GDP(Nonneman and Vanhoudt, 1996), Hall’sestimates imply that a five percentagepoint tax advantage to R&D wouldincrease R&D spending by 0.25 percentof GDP. Using a rate of return to R&Dspending of 30 percent (e.g., Griliches,1988), the net effect would be a 0.075increase in GDP growth rates.

A second possibility is that the hypotheti-cal tax cut, for example, on capital gains,would stimulate entrepreneurship andinnovation, which in turn would augmentproductivity growth. Poterba (1989)investigated the tax incentives faced byventure capitalists, and concluded thatventure capital was only a small fractionof total capital income, so that tax cutswere a blunt sword to encourage high-tech industries. Furthermore, tax-exemptinstitutions provided a large fraction ofstart-up funds, and these institutions arenot subject to income taxation.

A somewhat different picture emergesfrom a recent study quantifying laborhiring decisions by self-employedworkers. Carroll et al. (1996) found thata six percentage point decline in themarginal tax rate of a (Schedule C)entrepreneur in the top tax bracketincreased by 11 percent the likelihoodof hiring at least one employee.However, the magnitude of theseeffects and their impact on aggregateemployment are just not well enoughunderstood to hazard a numericalestimate of their growth effects.

Summing Up

To complete our bottom-up analysis, wesimply add the growth effects based on

changes in human capital, investment,and technological growth. The long-runeffects of our hypothetical major taxreform are estimated to be 0.22percentage points, while the short-termeffects, which include the transitionaleffects of increased labor supply,increase to 0.28 percentage points.

Aside from the uncertainty inherent innearly every empirical parameter used inthese calculations, there are somefurther caveats. First, the calculationignores the reduction in the sectoraldistortion of capital and labor, which, inthe section on cross-country regressions,was found to be important. Andsecond, these estimates reflect auniform reduction of five percentagepoints in marginal tax rates for allincome-generating activities. It may bethe case that tax cuts in capital gains, ortax credits for R&D, coupled withincreases in consumption taxes, or ashift to a flat tax, could yield muchstronger growth effects with less pro-nounced revenue effects. Nevertheless,these results suggest growth effectsfrom major tax reform on the order ofone-quarter of one percent per year.

LESSONS FOR POLICY

While the last word on taxation andeconomic growth certainly has not beenheard, there are some lessons that wethink can be taken from the evidencethus far.

First, we think that tax policy does affecteconomic growth. There is enoughevidence linking taxation and outputgrowth to make the reasonable infer-ence that beneficial changes in taxpolicy can have modest effects onoutput growth. The implied effects fromthe “bottom-up” microlevel studies andthe “top-down” cross-country regres-sions are quite close in magnitude: a


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major tax reform reducing all marginalrates by five percentage points andaverage tax rates by 2.5 percentagepoints is predicted to increase long-term growth rates by between 0.2 and0.3 percentage points. Whether theseeffects on output growth are permanent(lasting forever) or transitory (lastingperhaps 10 to 15 years) is difficult todetermine, both because our datasources do not extend for a lengthyperiod and because tax regimes them-selves generally have such short half-lives.

Second, even these modest growtheffects can have an important long-termimpact on living standards. For example,suppose that an inefficient structure oftaxation has, since 1960, retardedgrowth by 0.2 percent per annum.Accumulated over the past 36 years, thelower growth rate translates to a 7.5percent lower level of GDP in 1996, or anet reduction in output of more than$500 billion annually. So the potentialeffects of tax policy, although difficult todetect in the time-series data, can bepotentially very large in the long term.

Third, it appears highly unlikely that pasttax reforms have been self-financing inthe aggregate. There is evidence thattax changes focused on high-incometaxpayers may be self-financing,perhaps because of changes in financialarrangements as well as shifts ineconomic activity (e.g., Feldstein, 1995;Feldstein and Feenberg, 1996). Ofcourse, the historical record does notrelate specifically to a flat tax or aconsumption-based tax, which couldhave quite different effects, but wethink it unlikely that any tax systemcould engender the long-term increasesin growth rates necessary to completelypay for the tax cuts.

We want to be careful here about thecontext of our conclusions about

taxation and growth in the policydebate over dynamic scoring. Typically,dynamic scoring of tax revenue inresponse to changes in the tax codeinvolves two adjustments: one is themicroeconomic change in the tax base,holding constant macroeconomicvariables, and the other is the change inmacroeconomic climate caused by thetax reform (Auerbach, 1996b). Here, wesay nothing about the first, micro-economic effects, which could well bequite large (as in the short-termresponse of capital gains realization tochanges in the capital gains tax cut).We simply claim that the second,macroeconomic, effect is likely to bequite modest.

Fourth, a major shortcoming with nearlyall cross-country and time-series studiesis the difficulty of measuring themarginal tax burden appropriately. Theaverage tax rate does not reflect themarginal tax burdens hypothesized toaffect economic decisions. Even stat-utory marginal tax rates may not ad-equately reflect the quite complexintertemporal incentive effects of acomplex tax system. In many countries,tax policy is administered at the locallevel, where the tax collector may noteven have a current copy of the relevantstatutes.

Fifth, the composition of the tax systemis probably as important for economicgrowth as is the absolute level oftaxation. Countries that are able tomobilize tax resources through broad-based tax structures with efficientadministration and enforcement will belikely to enjoy faster growth rates thancountries with lower overall tax collec-tions assessed inefficiently. In short, thedesign of the tax system is likely toexert a modest, but cumulativelyimportant, influence on long-termgrowth rates.


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ENDNOTES

We are grateful for the very helpful commentsfrom Darrel Cohen, Don Fullerton, William Gale,Kevin Hassett, Harvey Rosen, and Joel Slemrod.The opinions expressed in this paper are those ofthe authors and are not necessarily shared by theBoard of Governors of the Federal Reserve Systemor other members of its staff.

1 The Kemp Commission was formally known as theNational Commission on Economic Growth andTax Reform (1996).

2 For examples, see Gravelle (1995) and Gale (1996). 3 The two coefficients are not measured in the same

units because ki is expressed as a ratio of GDP andmi as a percentage change.

4 See Auerbach, Hassett, and Oliner (1994) for adiscussion of how α corresponds to the (net orgross) return on capital.

5 David (1977) suggests that much of the 19thcentury in the United States was characterized by atransition from a low to a high capital-intensityeconomy. On the other hand, King and Rebelo(1993) find that traditional Solow growth modelsgenerate implausible transition paths in shiftingfrom one equilibrium to another.

6 There is an extensive simulation literature showingtransitional gains in economic efficiency using theframework of dynamic computable generalequilibrium models; see Ballard et al. (1985),Auerbach and Kotlikoff (1987), Fullerton andRogers (1993), Auerbach (1996a), and Engen andGale (1996). Like the endogenous growthliterature, the results from such studies oftendepend on the structure of the simulation model.In a life cycle model with perfect certainty andperfect foresight, Auerbach and Kotlikoff (1987)and Auerbach (1996a) find quite dramatic shifts insome aggregate variables (such as saving rate)during the transition to a new steady state. In amodel with uncertainty about future earnings,Engen and Gale (1996) find more moderate shiftsin output and saving during the transition to a newtax regime.

7 Stokey and Rebelo (1995) provide an excellentsurvey of this literature and explain why thetheoretical simulation models differ so dramaticallyin their implications for growth.

8 For a discussion of these issues, see Alm (1996),Slemrod (1990, 1994, 1995), and Auerbach andSlemrod (1997).

9 Moreover, only eight percent said they had evenpostponed investment. Also see Holland (1969)for survey evidence on the labor supply of highlypaid executives.

10 Specifically, the survey question asked whether thetax cut would reduce or increase the “hurdle rate”or the minimum rate of return required beforeapproving internal corporate investments.

11 Including earlier periods is complicated by the factthat revised GDP figures are currently only availableon a consistent basis from 1959. Also, Lindsey(1990) notes that the Coolidge–Mellon cuts in the1920s affected only the top quarter of householdsas most U.S. citizens paid no income tax duringthat time.

12 During 1971–79, the economy expanded at anannual average rate of 3.5 percent including therecession years of 1974–75. Growth averaged 3.2percent over the 1982–89 period.

13 Sorting out the difference between supply-side anddemand-side expansions is important, sincedemand-side expansions tend to deflate later intorecessions, while supply-side shifts correspond topermanent improvements in the productivecapacity of the economy.

14 We are grateful to the authors for making thisdata on tax rates at different income percentilesavailable to us. Note that these tax rates onlyreflect the federal individual income tax and do notincorporate federal corporate income, earnedincome tax credit, payroll, or state income taxes.

15 An alternative measure of the tax distortion is thetop statutory federal income tax rate. The top ratereached its zenith during the 1950s and early1960s, when it was 91 percent. Since then it hasbounced steadily downward to 28 percent, briefly,in 1988, with a jump back to 39.6 percent by1993. (See Pechman, 1987, for a historicalsummary of most of this time period.) Theeconomic expansion of the 1980s coincided with amarked decline in top marginal tax rates, leadingsome to conjecture a causal relationship betweenthe cuts in top marginal rates and the economicexpansion. However, taking the long view (circa1960–88), a general decline in the top marginalrate occurred as average GDP growth rates tendedto fall.

16 In the King and Fullerton study, based on 1980data, West Germany exhibited the least degree ofintersectoral distortion, trailed closely by theUnited States. In the McKinsey study, the factorsidentified as important—the motivation ofmanagers to show profits, for example—areextremely difficult to quantify across countries on aconsistent basis. Furthermore, as Kevin Hassettpointed out to us, the productivity of the capitalstock may not necessarily be an indicator ofbetter organization. In the absence of perfectworld capital markets, a country may exhibit ahigher productivity of capital because capital isscarce (that is, the capital-labor ratio is low). Inthis case, an increase in the capital stock mightlower capital productivity but make the economybetter off.

17 The investment effect is calculated using the firstequation from Table 4 in Mendoza, Milesi-Ferretti,and Asea (1996), assuming that marginal laborand capital taxes are both cut by five percentage

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points, while the output effect assumes a marginalproduct of capital equal to 0.10 (Auerbach,Hassett, and Oliner, 1994.) Unfortunately, we haveno estimates from cross-country equations onlabor supply effects.

18 Empirical evidence from a cross section of statessuggests either that government spending yieldsno positive growth effects (Holtz-Eakin, 1994) orthat only educational spending yields positiveeffects (Evans and Karras, 1994). Aschauer (1989)argues that the productivity effects are quite large.

19 The commonly used Summers and Heston (1991)data include a grade, ranging from A to D, thatsummarizes the authors’ estimate of the reliabilityof the data. Engen and Skinner (1992) weightedtheir estimates with a numerical scale of thisreliability; results were similar, although standarderrors were smaller.

20 For a nontechnical discussion, see “The Real TruthAbout the Economy: Are Government StatisticsJust So Much Pulp Fiction?” (Business Week,November 7, 1994).

21 For example, Grier and Tullock (1989) find anegative correlation between output growth andthe growth of government expenditures, althoughthey do not interpret the correlation as reflectingreverse causation.

22 Ram’s (1986) estimated positive correlationbetween the growth in government spending andoutput growth appears to be an example of thisproblem.

23 The analogy is to market prices for competitivegoods; regressing price on quantity (or conversely)tells the researcher nothing about the nature ofthe supply curve or of the demand curve withoutfurther identifying variables.

24 This is the approach followed by Agell, Englund, andSödersten (1996) in considering the Swedish tax reformof the early 1990s. The bottom-up and top-downterminology is attributed to Slemrod (1995).

25 Lindsey (1987), Navratil (1994), Auten and Carroll(1995), Feldstein (1995), and Slemrod (1996) findevidence of behavioral responses to tax reforms bydocumenting increases in reported taxable incomesfollowing reductions in tax rates during the 1980s.However, it is difficult in these analyses oftaxpayers’ income to separate the effects of “real”responses—such as changes in labor supply—fromthe effects of compensation, timing, and reportingresponses.

26 We focus here on uncompensated elasticities,because we are considering a tax cut. However, ifgovernment expenditures are highly substitutablewith market consumption goods or if Ricardianequivalence holds, one might prefer to usecompensated elasticities, which are generally higher.

27 Strictly speaking, in the growth accountingframework in equation 1, the percentage growthrate mi will be unaffected by the higher level ofhuman capital because human capital growth is

defined in percentage terms. We instead consideran alternative renormalization in which thedenominator is the pre-tax-cut level of humancapital.

28 Government tax policy could also be used toencourage saving through targeted savingprograms such as IRAs or 401(k)s. While there issome debate about their effectiveness in increasingsaving (see the Fall 1996 issue of the Journal ofEconomic Perspectives), the macroeconomic effectsof these programs are probably not large giventheir modest size relative to GDP.

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