CBO on Supply-side Economics

Lower tax rates induce people to work more. Greater work effort induces greater tax revenue, offsetting some of the initial losses in tax revenue from the tax cut. I believe this effect is one of the key tenets of supply-side economics. Most mainstream economists agree, to some degree.

The big question is about magnitudes: How big is this effect? In a new report, CBO reports this estimate:

CBO estimates that the change in tax revenues from the shift in labor supply would offset roughly 4 percent of the static revenue loss.

The report is not blunt, but its bottom line is simple: Supply-side effects are trivial.

I don't buy it. To understand why the CBO reached this conclusion, the key seems to be found in Table 2. According to this table, the earnings-weighted compensated labor supply elasticity is 0.14. With such a small elasticity, their model naturally yields small behavioral responses to changes in tax rates.

In my paper with Weinzierl, we reviewed some of the literature and concluded that a reasonable number for this parameter was 0.5. Kimball and Shapiro concluded it is even larger. If one plugs 0.14 into the formulas Weinzierl and I gave, one would find effects as small as those reported by CBO. So the details of the different models do not appear central; this part of the macroeconomic debate seems to boil down to a single parameter. Unfortunately, the academic literature on this topic is far from conclusive. But I am not sure it was prudent for CBO to settle on the low end of the plausible range of estimates.

Herb Stein is supposed to have once said, "There is nothing wrong with supply-side economics that division by ten wouldn't fix." If my reading of the CBO report is correct, then there is nothing wrong with it that multiplication by 3 to 6 wouldn't fix.

Update: An informed reader tells me this particular study is only part of CBO's analysis of tax policy. For example, it does not deal with the offsetting spending changes that must eventually accompany any tax change. As I explain in another post, one cannot fully analyze tax policy without thinking through how the government budget constraint is satisfied. My friend recommends this CBO piece to get a better sense of the full range of models used.