Brookings Panel on Economic Activity April 2-3, 2009 Washington, DC

1. “Do Tax Cuts Starve the Beast?”by Christina Romer and David RomerRemarks by Steven J. DavisUniversity of Chicago Brookings Panel on Economic Activity April 2-3, 2009 Washington, DC

2. Starving the Beast – What Is the Mechanism? • Debt servicing requirements are a claim on government revenues. • Assumption: Rising marginal costs of raising government revenue and non-increasing marginal benefits of spending (for PM) • Implication: OTE, a government that inherits more debt spends less, net of debt servicing. • Mechanism:Bequeath more debt to future government, raise servicing costs, and thereby limit future spending

3. Strategic Beast Starving • Current PM anticipates that future PM has a stronger taste for public spending • Compared to situation where current PM expects to retain power, current PM taxes less and runs a bigger deficit. • Why? To constrain future spending. • Persson and Svensson (1989, QJE) • Current PM anticipates that future PM wants a different type of spending • Compared to situation where current PM expects to retain power, current PM spends more on its preferred type of spending and runs a bigger deficit. • Why? To constrain future spending on the type of spending that current PM dislikes. • Alesina and Tabellini (1990, RESTUD)

4. No Starvation Diets in this Sample • If deficit-financed tax cuts raise debt-GDP ratio by 5 percentage points and r=2% per year, then debt servicing costs rise by (.05)(.02)=0.1% of annual GDP  Desired non-interest spending falls by 0.1% of GDP if MB of G is flat, less if MB declines with G • Even less strain on government revenue requirements if tax cuts stimulate growth. • More strain if higher debt causes r • Conclusion: Mechanism is too weak for detection by RR method in sample of postwar U.S. tax changes.

5. Another Mechanism Tax changes are sticky – hard to reverse • Magnifies force of basic mechanism, because tax changes implemented by current PM carry forward • Large # of tax changes documented by RR suggests limited stickiness for “routine” tax changes • Stickiness could be a very important factor for out-of-sample changes • Elimination of corporate income tax system • Adoption of VAT or national sales tax

6. What’s the Beast?“Big G” or “Big Welfare State”? • Reagan opposed Big WS, favored defense • Many other advocates of beast starving are more concerned about Big WS than Big Defense • If Big WS is target, a focus on total G can mislead • Reagan cut taxes and initiated a persistent rise in defense spending • Both created fiscal pressures to restrain WS , but the rise in defense spending muted decline of total G • Another issue: If defense spending is less responsive to fiscal pressures, then beast-starving effects load disproportionately onto WS spending. • In line with Figure 5.d

7. Deficit-Fighting Tax Hikes • Often accompanied by modest spending cuts • Example: Clinton tax increase of 1993 • RR regard these changes as uninformative about starve-the-beast hypothesis, because they reflect a “switch to fiscal responsibility” • But the need for deficit-fighting tax hikes and spending cuts, when caused by deliberate tax and spending decisions of previous PM, is evidence for strategic beast-starving behavior. • Persson and Svensson (1989)

8. Concerns about Counterfactuals and Exogeneity • Suppose PM foresees rising political pressure for public spending (e.g., because of population aging) • In response, PM cuts taxes now to limit or slow future spending growth. • Spending grows, but less so because of tax cut • RR interpret this pattern as evidence against starve-the-beast effects, even if the tax cuts restrain spending growth. • Suppose tax cuts are more likely when PM foresees strong growth and a lessening of fiscal pressures • In response, PM cuts taxes now and expands spending over time. • RR interpret this pattern as evidence against starve-the-beast effects, even though both tax cuts and spending growth reflect anticipations of strong growth

9. Summary • An admirable effort, but not persuasive • Concerns about exogeneity and counterfactuals • Large standard errors • Too little variation to detect effects of mechanism • Issues related to defense spending vs. WS spending • Figure 5.d says long run nondefense spending falls by 40% of tax cut amount (big standard errors) • A priori reasoning implies the basic mechanism is weak for tax change episodes in postwar U.S. • Frequency of tax changes suggests that stickiness mechanism also lacks force for routine changes • Nothing here diminishes Becker-Mulligan-type concerns about spending consequences of VAT and other efficient taxes.

10. References Becker and Mulligan, 2003, “Deadweight Costs and the Size of Government,” J Law&Economics Alesina and Tabellini, 1990, “A Positive Theory of Fiscal Deficits and Government Debt,” RESTUD. Persson and Svensson, 1989, “Why a Stubborn Conservative Would Run a Deficit,” QJE. Romer and Romer, 2009, “Do Tax Cuts Starve the Beast?” BPEA, forthcoming.