The Bush Tax Cuts: What are the indirect effects on economic growth?
The manner in which tax cuts are financed can affect long-term economic growth, but the effect is tricky to analyze in the case of the Bush tax cuts because their ultimate financing remains unclear. So far the tax cuts have been financed with higher budget deficits. If extended, the tax cuts will increase the accumulated federal debt by $5 trillion in 2015, or 25 percent of GDP in that year. The accumulation of these deficits will injure long-term economic growth, because budget deficits reduce national saving, which in turn reduces the rate at which the economy accumulates capital.
- Increased budget deficits need not reduce long-term growth if they are fully offset by an increase in private saving. However, history suggests that increased private saving by Americans will suffice to offset only about one-quarter of the increase in public debt. On net, then, national saving is likely to fall by 75 cents for every dollar in deficits. This implies that the capital stock owned by Americans after a decade would be $3.75 trillion (75 percent of the $5 trillion in additional public debt) lower than if the tax cuts had never been enacted. If capital earns 6 percent (a reasonable assumption), that "missing" $3.75 trillion in American-owned capital will reduce national income in 2015 by $225 billion, or about 1 percent of GDP in that year as projected by the Congressional Budget Office.
- The reduction in the domestic capital stock due to budget deficits is facilitated by an increase in interest rates. A variety of estimates suggest that the rise in budget deficits in the next decade will raise long-term interest rates by about 1 percentage point, or perhaps a little less. Higher interest rates mean that firms will have to pay more to borrow funds for investment in plant and physical equipment, and they will have a greater incentive to use their internally generated funds for financial investments instead of investing in their business. The cost of capital would rise for corporate equipment and structures, noncorporate equipment and structures, and owner-occupied housing. This higher cost of capital would reduce new investment.
- Large and sustained budget deficits would also reduce future national income through increased borrowing from abroad by American households, firms, and government. Such borrowing in effect "mortgages" the income generated by part of the U.S. domestic capital stock. In other words, the future returns to the domestic investments financed by foreign borrowing would accrue to foreign investors rather than U.S. residents. This effect is included in the estimated $225 billion loss to national income cited above.