The Rosen-Laffer Curve: The Steady State Does Not Appear Overnight

Brad DeLong is still unhappy with a paper from Harvey Rosen with one of his many legitimate complaints being:

starting with what seems to me to be an overstated supply-side boost (3%) and then considering only even larger effects (5%, 7%) rather than smaller effects

Rosen says he got this 5% from John Diamond who claims that a tax reform that combined base broadening and reductions in marginal tax rates could boost national savings such that output would eventually be over 5 percent higher with eventually being defined as a decade from now. Rosen also references a paper by David Altig et al. that we noted here. Permit me to quote just one paragraph:

The model predicts significant long-run increases in output from replacing the current U.S. federal tax system with a proportional consumption tax. For our base case, output would rise eventually by more than 9 percent. For middle- and upper-income classes alive in the long run, this policy is a big winner. But older transition generations suffer from the imposition of an implicit capital levy, and low-income individuals, even in the long run, suffer a significant loss as growth fails to compensate for the decline in tax progressivity.

Note that both of the papers cited by Rosen as evidence for significant output effects specify that they are referring to eventual increases in output not immediate increases. Anyone even remotely familiar with standard long-term growth models should recognize that obtaining faster growth rates requires a current sacrifice of consumption – that is an increase in national savings. Output slowly grows over time, which allows the economy to enjoy the eventual fruits of its current sacrifice. As I noted, the paper by Altig et al. envisioned:

the kind of supply-side experiment reasonable conservatives such as Bruce Bartlett advocate, which include not only reductions in marginal tax rates but base broadening changes in the tax code so as to effectively pay for revenue losses from the reductions in those marginal tax rates, that is, a fiscal policy change that is deficit neutral even before we worry about any alleged supply-side benefits.

Team Romney, however, wants us to believe that these supply-side benefits can come immediately and that lower income people do not have make sacrifices in the form of paying higher taxes. These conclusions, however, do not follow from any form of reasonable economic analysis that recognizes that long-term growth occurs only slowly over time. That Greg Mankiw apparently endorsed this incredibly sloppy and misleading application of growth theory should have both Harvard University and Cengage Learning (his publisher) worried. If he does not understand that growth effects take considerable time, then is he really qualified to teach macroeconomics? If he does understand this critical point, then why would he endorse Rosen’s paper with its table entitled “Revenue Consequences of the Romney Tax Reform” that included “Additional tax revenue from rise in incomes due to higher incomes” since that “macro-dynamic behavioral responses” would not fully materialize for several years?