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08-Mar-2019 08:51

But base-broadening has the additional benefit of reallocating resources from sectors that are currently tax-preferred to sectors that have the highest economic (pre-tax) return, which should increase the overall size of the economy.

A fair assessment would conclude that well-designed tax policies have the potential to raise economic growth, but there are many stumbling blocks along the way and certainly no guarantee that all tax changes will improve economic performance.

Policy makers and researchers have long been interested in how potential changes to the personal income tax system affect the size of the overall economy.

In 2014, for example, Representative Dave Camp (R-MI) proposed a sweeping reform to the income tax system that would reduce rates, greatly pare back subsidies in the tax code, and maintain revenue levels and the distribution of tax burdens across income classes (Committee on Ways and Means 2014).

Section V examines the new “narrative” approach to identifying tax changes that are exogenous to current economic conditions, stemming from the seminal work of Romer and Romer (2010).

The literature, which generally uses vector autoregression (VAR) models, finds that tax cuts that meet the exogeneity criteria raise short-term output and other economic activity.

Section II provides a conceptual framework by discussing the channels through which tax changes can affect economic performance, including the many ways in which a positive substitution effect in response to a tax rate cut might be dissipated or even reversed by other factors. We show that growth rates over long periods of time in the United States have not changed in tandem with the massive changes in the structure and revenue yield of the tax system that have occurred.

Consistent with the discussion in Section III, the studies find little evidence that tax cuts or tax reform since 1980 have impacted the long-term growth rate significantly.

Tax cuts financed by immediate cuts in unproductive government spending could raise output, but tax cuts financed by reductions in government investment could reduce output.

If they are not financed by spending cuts, tax cuts will lead to an increase in federal borrowing, which in turn, will reduce long-term growth.

Our focus is on individual income tax reform, leaving consideration of reforms to the corporate income tax (for which, see Toder and Viard 2014) and reforms that focus on consumption taxes for other analyses.

By “economic growth,” we mean expansion of the supply side of the economy and of potential Gross Domestic Product (GDP).The historical evidence and simulation analyses suggest that tax cuts that are financed by debt for an extended period of time will have little positive impact on long-term growth and could reduce growth.