Academic journal article Journal of Money, Credit & Banking

Budget Balance, Welfare, and the Growth Rate: "Dynamic Scoring" of the Long-Run Government Budget

Academic journal article Journal of Money, Credit & Banking

Budget Balance, Welfare, and the Growth Rate: "Dynamic Scoring" of the Long-Run Government Budget

Article excerpt

It has long been recognized that a reduction in the tax rate applied to an economic activity leads to an increase in the taxed activity, thereby offsetting, at least in part, the direct loss in tax revenues resulting from the lower rate.(1) In fact, it is even possible that the induced increase in the tax base can dominate, leading to an overall rise in revenue collections. This possibility was popularized by Laffer (1979), who argued that cuts in income tax rates would result in higher tax revenues because of increases in the labor supply, entrepreneurial activity, and the reduced use of tax shelters.(2) Although Laffer's prediction may conceivably hold for very high income tax payers (see Slemrod 1994), most analysts agree that income tax cuts do not generate higher revenues from taxing earnings because the elasticity of the labor supply to the after-tax wage is too small.

Nevertheless, the proposition that high tax rates depress economic activity to the detriment of revenue collection remains a cornerstone of supply-side tax policy and is often raised in policy debates. Recently, a variant of the argument that a cut in income tax rates can improve the revenue situation of the government has gained currency. Whereas the original argument was static, in that it requires a cut in tax rates in a given period to generate a sufficient increase in the tax base of that same period, the new argument is explicitly dynamic, in that it focusses on the effect of a tax cut on the growth rate in the economy and hence on the growth rate of the overall tax base. Higher growth rates resulting from a lower tax rate may lead to higher tax revenues in the future, raising the possibility that a reduction in the current tax rate may nevertheless increase the present discounted value of all future tax revenues. This is possible even if the impact on the current tax base is small so that current revenue declines. Taking into account induced changes in the growth rate is sometimes described by budget officials as dynamic scoring.(3)

The idea that a reduction in the income tax rate can generate sufficient growth to raise the present discounted value of tax revenues and improve the long-run fiscal balance of the government deserves serious analysis. Most current discussions of fiscal policy recognize its inherent dynamic nature, and the importance for the government to remain intertemporally solvent; see, for example, Aschauer (1988), Barro (1989), and Auerbach (1994). In order to cast light on the conditions needed for the dynamic version of the revenue-enhancement argument to hold, this paper addresses the issue of long-term fiscal balance employing a simple endogenous growth model, characterized by continuous balanced growth. The model abstracts from any transitional dynamics, enabling the trade-off between the short-run and long-run effects of once-and-for-all changes in fiscal policy to be highlighted by comparing the current flow effects of a tax cut with the intertemporal growth effects.

One important characteristic of the endogenous growth model is that the equilibrium growth rate is sensitive to fiscal policy.(4) This feature has led several authors to employ such models to analyze the effects of fiscal policy on long-term economic growth; see, for example, Barro (1990), Jones and Manuelli (1990), Rebelo (1991), Jones, Manuelli, and Rossi (1993), Pecorino (1993), and Turnovsky (1996). But in focussing on growth and its implications for the behavior of the private sector, and by assuming lump-sum tax financing or, in some cases, a continuously balanced budget, these authors do not address the consequences of such policies for the long-run fiscal balance of the government. One recent paper that does address this issue is Ireland (1994). He simulates the impact of a change in the income tax rate in a simple endogenous growth model, in which government expenditure acts purely as a drain on the economy. He shows that the long-run growth effect of a tax cut can eventually overtake the short-run effect on the budget balance, resulting in an improvement in the long-run government balance. …

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