Tax Cut Worries

So the issue is: how likely is it that the area will be greater than the area?

The size of the area, the tax revenue from the increase in production, depends on

How big the increase in investment is, in response to a cut in taxes
How big the increase in production is, for each dollar of investment, that is, the marginal productivity of capital

The product of these changes has to be "big enough" to keep the total revenue from falling. So the question becomes, how big is "big enough?" and is it likely that the responses would be "big enough?"

One way to express this could be to define an elasticity of response of production to a tax change. Following the example of the price elasticity of demand, the elasticity of response would be minus

the percent change in production

the percent change in the tax rate

Of course, the elasticity of response is defined "ceteris paribus" and might change if circumstances changed. For example, the elasticity of response probably would depend on the kind of tax cut enacted -- whether, for example, taxes on wages, the social security tax, or capital gains taxes were cut, and in what proportions.

Now, "how big is big enough?" The cut in taxes would lead to an increase in tax revenues only if the elasticity of response is greater than one. Let's see what that means with a realistic numerical example. Suppose we begin with a real GDP of 6 trillion dollars and the tax rate is cut from 18% to 17%. That's a cut of slightly under 6%. Thus, in order for the elasticity of response to be greater than one (and in order for revenues to rise rather than fall) the increase in production would have to be about 6%. Beginning from 6 trillion, a 6% increase in production is 360 billion dollars of new production. How much investment would that require? Historically, it has taken about 3 dollars of investment for each new dollar of production in the U. S. So the Supply Side tax cut would have to stimulate new investment of 3*360 = 1080 billion dollars of new investment in order to succeed. So far in 1996, a good year, real gross domestic investment has been slightly under 1020 billion dollars per year. (Investment numbers are adjusted for inflation). Thus, to succeed, a Supply Side Tax Cut would have to cause investment roughly to double. The fifteen percent tax cuts mentioned in recent political debates would require investment almost to quadruple.

In the post-World War II period, real investment has never doubled nor even increased by as much as 50% in a period of five years or less. In the late 1930's and early 1940's, when the economy was recovering from the extraordinarily low investment rates of the Great Depression, investment did double in five years or less, but there is little reason to think that could happen in the conditions of the period 1960-1996. Thus, it seems very improbable that a Supply Side tax cut could succeed -- so improbable that a commentator said the proposal "fails the laugh test."

Some Experience