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.