Republicans “lost” the negotiations over the fiscal cliff, in the minds of some, when they acceded to higher tax rates on income over $450,000, as well as on estates over $10 million. With future negotiations bound to occur over the debt limit as well as within the context of possible tax reform, many Republicans think the goal of any future deal should be to reverse those tax increases to increase economic growth.

This begs an important question: Just what, exactly, does the economy gain if we do roll back the tax increases in the context of some sort of wholesale change in the tax code?

Economic theory suggests that lower tax rates stimulate economic growth by increasing the returns to work and invest and other economic activity. Right now, living in the high-tax District of Columbia, for every additional $10,000 I earn, I get to keep only $5,500 of it.  Or, put differently, to pay for a $100 dinner in my neighborhood, I have to earn another $200, to cover the meal, my income tax, and the sales tax. Lower tax rates mean we get to keep more of each dollar we earn, so we work more, invest in more human capital, earn more, and ultimately pay more in taxes as well. With lower taxes on corporate income, companies invest more, which makes workers more productive, and that increases employment and wages.

However, when we finance lower taxes by deficit spending, a school of economic thought (to which I am sympathetic) says that people rationally recognize that this is unsustainable and that taxes have to go up in the future to cover the deficits being accrued in the present. So people set more money aside in anticipation of higher taxes (all of the additional money they get from the tax cut, in a world without liquidity constraints) and we get only a small change in economic activity.

The answer we don’t like to hear is that as long as we’re spending as much as we are, changes to the tax code can’t provide short-term stimulus (take that, Paul Krugman), and a tax reform that is done in the face of trillion dollar deficits won’t do as much as we want it to do in terms of economic growth either.

Therefore, the true path to higher economic growth is to combine low tax rates with low levels of government expenditures. For the United States, that would mean first and foremost reforming our entitlement system, which currently comprises over 60% of federal spending and is careening wildly towards insolvency.

While revamping our tax code to eliminate needless tax expenditures would be a net benefit for economic growth, any tax changes that occur without entitlement reform — that assures taxpayers that our financial house is in order — will have a relatively modest impact on the economy.

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