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Sakmongkol ak 47

Tuesday 9 December 2008

Tax cuts and the Economy(1)

Lets get over a very boring subject- the economics of tax cuts. So far only a few bloggers find it interesting to discuss these things. As far as I know, people like De Minimis( an economist/lawyer), etheorist( perhaps the only bona fide economist among us bloggers), Analyst at Large and the astute commenter, Walla are into this topic. It is a dry subject and Economics is known as the Dismal Science anyway. But we gain satisfaction because we are comforted by the thought that we can disagree civilly sans the usual acrimony that accompany difference in opinions.

How do we stimulate the economy? Just suppose we decide to cut income tax. This means, our take home pay after tax is larger. People have more income. The poor suddenly find they have more money to spend. This is supposed to have a good impact on the economy as it increases private spending. Private spending is one of the components of aggregate demand. The argument then is, when private spending is increased, aggregate demand is raised.

I am initially very enthusiastic over this idea. Who wouldn’t want to have more money in hand? Personally, having more money is good. But how much is the effect of household spending on economic growth? Compared to say, investment spending? Do consumers behave and spend in the direction, economists want them to, i.e. spend on productive capacities? Will the multiplier effects generated from consumer spending be large? Large enough for example to offset the reduced revenue arising from tax cuts? How do we finance the tax cuts?

Consider the effects of tax cuts on deficits, the economy, and the distribution of income. Therefore just for the sake of honest discussion, let us see. Supporters of the tax cuts have sometimes sought to bolster their case by understating the tax cuts’ costs, overstating their economic effects, or minimizing their regressivity.

It is always a boon to look at example in other economies. Take the case of USA. Congressional Budget Office data show that the tax cuts have been the single largest contributor to the re-emergence of substantial budget deficits in recent years. Legislation enacted since 2001 added about $3.0 trillion to deficits between 2001 and 2007, with nearly half of this deterioration in the budget due to the tax cuts (about a third was due to increases in security spending, and about a sixth to increases in domestic spending). Yet people decline to acknowledge the tax cuts’ role in the nation’s budget problems, falling back instead on the very debatable nostrum that tax cuts “pay for themselves.” It pays too little and that leaves a big gap in the country’s finances.

The argument is that tax cuts dramatically boost economic growth, which in turn boosts revenues by enough to offset the revenue loss from the tax cuts. Unfortunately this optimism is not borne out by empirical studies. Simulation studies carried out on effects of extending tax cuts found that, at best, the tax cuts would have modest positive effects on the economy; these economic gains would pay for at most 10 percent of the tax cuts’ total cost. Under other assumptions, studies carried out by the US Treasury found that the tax cuts could slightly decrease long-run economic growth, in which case they would cost modestly more than otherwise expected.

The claim that tax cuts pay for themselves also is contradicted by the historical record. In 1981, the US Congress substantially lowered marginal income-tax rates on the well off, while in 1990 and 1993, Congress raised marginal rates on the well off. The economy grew at virtually the same rate in the 1990s as in the 1980s (adjusted for inflation and population growth), but revenues grew about twice as fast in the 1990s, when tax rates were increased, as in the 1980s, when tax rates were cut. Similarly, since the 2001 tax cuts, the economy has grown at about the same pace as during the equivalent period of the 1990s business cycle, but revenues have grown far more slowly. Therefore it is not necessarily true that the main reason for our growing economy is that we cut taxes and left more money in the hands of families and workers and small business owners

Let’s say that we extend the tax cuts to cover capital gains and dividends. Theoretically it would be logical to expect the said tax cuts to stimulate the economy, resulting in higher employment. Again, not strictly true. This was what USA did in 2003 but the available evidence indicates that the capital gains and dividend tax cuts were not the cause of improvement in the US economy in 2003.

Supporters of tax cuts on capital gains and dividends have not produced evidence to support their leap from correlation (the tax cuts coincided with improvement in the economy) to causation (the claim that the tax cuts caused the improvement). Furthermore, they have ignored evidence that indicates there was little or no causal connection. Even before the tax cuts, observers such as Federal Reserve Chairman Ben Bernanke (then a Federal Reserve Board governor) were predicting improvement in the economy before the 2003 tax cuts were enacted. In addition, supporters of enacting these tax cuts, such as conservative economist Gary Becker, acknowledged at the time that, whatever the tax cuts’ long-run effects on economic growth, they would not boost the economy in the short term.


Small Talk 9 December 2008 at 11:19  

Just one thing. U said "Just suppose we decide to cut income tax. This means, our take home pay after tax is larger. People have more income. The poor suddenly find they have more money to spend."

I am just wondering whether the "poor" in Malaysia have to pay income tax?

If one lives in KL with 1 wife and 5 children for example, earning RM5,000.00 is considered "poor". But if one lives in Raub or Pekan, I guess one can be called "rich".
In 1982 when I joined the Govt Service, my starting pay was $1060.00 (Those days they use $ & not RM)and I felt "rich" and my shopping was at PJ Supermarket Section 14 and I drove the Ford Laser S Black Beauty!
Ah... I got an A for Economic for HSC and they put me to study Law..and here I am arguing about the cow jumping over the moon!

Shall we petition the PM from your hometown to actually define "poor"? Oh poor me!

de minimis 9 December 2008 at 13:14  

There are, of course, 2 aspects to tax cuts. The one that excites the masses is the personal income tax. The effect of persona income tax cuts on consumption and, therefore, aggregate demand may not be significant.

Sometimes fiscal policy is directed more specifically at corporate income tax. Here, a gradual reduction in income tax may have a salutary effect since the surplus can be re-invested by the companies.

On this specific point of reducing corporate income tax, the main issue is this - Sak has mentioned Scandinavian countries and their high-tax regime. etheorist has embellished Sak's point with the observation that Scandinavian taxpayers find the high-tax rate tolerable because the Scandinavian govts provide a SOCIAL SAFETY NET (this is a principle worth looking into a some point).

Which all leads to the question of the comparative economic policies and strategies deployed by the Malaysian govt compared and contrasted with the Scandinavian govt.

I will only make one observation for now. Norway made a conscious decision on managing its oil wealth in this manner. The point is that there are, indeed, many ways towards economic progress, economic development and social-distributive fairness. We are all seeking ways and means.

It is wonderful to be able to meet like-minded seekers in the blogosphere.

It may be boring to the itinerant blog visitor. But, where else can we find a solid economics and development discussion that is free from rant and rave?

So, I ask for forgiveness for the sin of being boring. Perhaps it is precisely this sense of boredom with economic issues that has led to unaudited economic "leakages" in Malaysia's economy.

Ariff Sabri 9 December 2008 at 13:58  

de minimis,

bro, that's what i meant. the itinerant reader finds economic dicussions boring and by extension, unfortunately people like us who want to open up discussion about economics are regarded boring. waah.

the very poor never pay income tax. probaly in Malaysia now, there are about 1.2-1.5 million taxpaying people in malaysia.
we are included in the poor category. those rich ones are those umnoputras who work as professional lobbyists. maybe we should join them too, haha.
ye lah..notice you hv to argue about the cpw jumping over the moon lately, with order of mandamus and judicial review. adoi...

etheorist 9 December 2008 at 15:46  


Thank you for your honourable mention. Of course, I owe very much my undeserved spot of light to de miminis.

I write to clear my own mind. So, my apologies to those who are inadvertently subjected to it.

Your recent foray into economics is a welcome improvement to the dicussion. We really need to get off econ 101.

The key to growth is investment. So if the surplus wealth is going into consumption, it must as well go to improve the poor and boost their productivity.

I have unsuccessfully tried to argue with policy makers why government deficit is important for a developing economy.

The deficit is an addition to the national income. If taxes are fully used as operating expenditure, then the deficit is development expenditure.

If we use development expenditure well - education, not guns - then we'll be on the road to a better life for all.

Icarius 9 December 2008 at 17:05  

Hi Sir,
Firstly, thanks for very interesting reads on your blog.

While agreeing with you that tax cuts may not provide the boost needed to kick the economy, I do have a few questions that I hope that maybe you and your readers can help me understand.
I just hope that the questions do not deviate the discussion away from tax cuts and economy. Also, please forgive me for the layman language as I have little knowledge of economics, other than what the thinking man on the street can observe.

1. When there are personal tax cuts, it typically benefit the income above-average income group since it is the higher income earners that earns enough to be taxed.
In that sense, it doesn't put money into the pockets of the 'poor'. (except for the urban poor, maybe?). I have no basis for this but probably any reduction of taxes will merely increase the disposable income of the above-average, which will in turn spend most of it on imported goods.
So if tax cuts does not benefit the poor nor an economy in distress, would it make sense to put forward a hypothesis that it is the rich that can gain from such (who else gains from dividends and property tax cuts?) and that the very same rich are in power or influence to cut taxes? And that a bad economy is the greatest excuse for cutting taxes?

2. Regarding what DSN says, unfortunately, it is true. The urban or suburban population are live at higher costs and pay more taxes than the rural, making them 'poorer' with the same income.
And more of these collected taxes are spent on the rural areas than on urban areas. That is, the government spends more money on each rural person than on each urban person. Again, I speak without proof, but maybe one of the real economists can test this view?

3. Putting more money (by cutting corporate tax) into companies may promote investment for growth, provided that if we can sustain and grow consumption. If we (and the world at large) are already in over-production, then increasing investments to produce more may not be the solution at all. (To take an extreme example, imagine if we build another assembly plant for Proton)
Is it reasonable to consider that we and the world may be in a state of over-production?
And if the world is in a stage of over production, what then should be the way keep the economy growing? Is it necessary to even grow?

4. These may be the stupidest questions that any of you may have ever heard (or read), but please bear with me.
Commonly accepted assumption:
It is important to that we have economic growth, because economic growth provides more jobs and more money. This is so that the income earners have more money to spend and therefore have a better life.

Why is it so important that a person, business, or country must grow and become 'bigger' every single month, quarter or year?

Why is it not acceptable that economies that grow need to slow down and even reduce a bit once a while? Like us human climbing stairs need to take a breather once a while. As long as we can continue climbing after the rest, we will eventually reach where we want to be.

5. Going back to the 'source' of this economic disaster, is the sub-prime mortgage problem (that started this whole economic collapse) the explosive, or was it merely the spark that triggered the explosives (which was already gathered awaiting from over-production and other causes)?


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