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Tax Cuts Are Not The Answer


While Beacon Economics does not yet see any sign of a double dip recession in the U.S. economy, we also acknowledge that things are not, by any means, fine. The nation continues to grow sluggishly, leaving a lot of excess capacity – represented most starkly by the continued high rate of unemployment. Contrast this to the past two deep downturns in 1982 and 1974 after which the U.S. economy averaged 6% growth in the 2 years following the end of the recession, quickly catching the economy up with the long run trend. While that is clearly not happening today, tax cuts are simply not the panacea many seem to believe they are for our current economic woes.

First I need to make one thing perfectly clear: I am not a fan of paying taxes. I recognize that government involvement in the economy is necessary for the promotion of the public welfare. But the waste in terms of efficiency not to mention the funding of pork barrel projects for privileged special interests is at best frustrating and at worst criminal.

I mention this because I realize I will hear a howl of protest from the right when I point out something quite obvious—that cuts in public spending and tax cuts for individuals at any level of income are not going to cure what currently ails the U.S. economy.  Such a statement is close to blasphemy in some circles, but unfortunately neither the data nor the logic support the point of view.

First, take the idea of tax cuts as a stimulus for job growth. Tax cuts have been one of the primary tools used to try and stimulate the economy over the past decade, starting with President Bush after the 2001 downturn and continuing now with President Obama. The difference between the parties here is who should get the best deal. Republicans favor tax cuts for the wealthy, as they are the ‘job creators’. The Democrats favor cuts to middle and lower income households, such as the social security deduction, because they think that this has a more direct impact on consumer spending, and hence economic activity.

It is true that over the long run there appears to be a relationship between taxes and job growth. From 1970 to 2000 the tax rate gradually increased even as the average pace of job growth declined. But these two trends are not evidence of causality any more than the fact that because my waistline has increased over the past three decades as the economy has expanded, that a couple extra donuts in the morning would help fix the economy.

Indeed, it is the breaks from the trend that show the lack of causality. In particular the Bush tax cuts, which lowered overall tax rates substantially, did not lead to a new acceleration in job growth. Instead jobs stayed on their same slow downward trend. Looking back farther, a sharp increase in taxes at the end of the 1960s did not substantially lower job growth either. And most damning of all is that taxes, for the past 2 years, have been pegged to their lowest level for well over 50 years—and it hasn’t helped pull the U.S. out of its current slump.

It turns out that slowing job growth over time is largely due to a simple demographic formula—there has been slower growth in the number of working age adults in the U.S. If we look at the workforce participation rate, we can see that the percent of eligible adults who were working peaked in 2000—when tax rates were also at their peak.

This isn’t to say that there isn’t some relationship between personal taxes and economic activity. After all, we can intuit that if the tax rate were raised to 100%, very little formal economic activity would occur. But when we drill down into the range of interest at the personal level, the theory starts to break down a bit.

Consider the idea that high-income people are ‘job creators’. This may work as a clever sound bite, but it doesn’t pan out in reality. In fact the typical CEO or high paid banker is not a job creator, but a wealth maximizer—they maximize the value of the firm they work for on behalf of the shareholders or investors in their firm. This may occur on the basis of adding jobs, or subtracting them, depending on the state of the company. Their fiduciary duty to their clients does not change with a shift in their personal tax rate. Indeed, if your CEO starts to make bad decisions based the fact that his/her income net of taxes drops from $10 million per year to $9.5 million per year, I suggest its time to find a new CEO.

Even in the most extreme case, where a firm is owned and operated by one individual, income taxes shouldn’t impact the level of economic output. After all, basic economic theory suggests that a firm should continue to produce units until the marginal profit from producing one more unit falls to zero. Since profit or incomes taxes are a percentage of total profits, this implies that as long as the full marginal profit is greater than zero, then so too is the net marginal profit. As such raising or lowering the percentage will not have any material impact on operations at the company.

So, soak the rich and give the tax savings exclusively to the middle classes? Well, no, this isn’t right either. It is true that tax cuts for the middle class would likely stimulate more consumer spending than another marginal dollar for a high income individual. But it isn’t clear that this marginal consumer dollar will do much for the U.S. economy.

Remember that the purpose of stimulus is to promote domestic production, since this is what will create jobs. But when consumers begin to spend more of their income on consumption, most of this seems to go to goods, not services—and these goods come in large part from imports. In other words, much of the stimulative value of these additional dollars spills out of the U.S. and into the world economy. Tax cuts for middle class consumers have more or less contributed to the U.S. trade gap’s failure to close since the recession ended.

Where taxes do start to play a major role is in the location decision of a firm or individual. When taxes rise in one place relative to another, changing locations to a lower tax location can make economic sense. As such, lowering the corporate tax rate for firms in the U.S. might cause some firms to bring their operations back into the country.

But even here there is little in the way of an immediate relief. First, the location decision of the firm or individual is based on many more factors than just the relative tax rate. Grover Norquist, head of Americans for Tax Reform, has long claimed that there is clear evidence of people and firms moving from high tax states to low tax states. Sadly his claims are completely devoid of truth. Some high tax areas including California and New York City have grown very rapidly over the past few decades, along with low tax areas such as Texas.

This isn’t to say that lower taxes in California would not have led to faster growth rates. It is only to say that the factors that drive the decision of where to locate are many and varied. Moreover, such decisions take years to make and implement. Lowering the corporate tax rate (and leveling the playing field by removing perks and subsidies for specific industries) is important for the long run health of the U.S. economy—but its unlikely to have but a mild impact in the short run.

The other part of the fiscal platform of the Republicans is that tax cuts should be matched with a sharp reduction in Federal spending in order to close the deficit. This logic has been highlighted in a paper by two Harvard economists “Large Changes in Fiscal Policy: Taxes Versus Spending”, by Alberto Alesina and Silvia Ardagna. The argument goes something like this: A closing of a Federal deficit can increase confidence in the economy’s health and free up capital for private sector use – thus, closing a deficit can stimulate private sector growth. They then go on to give results of such a relationship.

Unfortunately a number of other papers have since been released, most significantly “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation” from the IMF’s World Economic Outlook, that point out substantial flaws in the data used by Alesina and Ardagna. By the accounting of the researchers at the IMF closing a government deficit by 1% of GPD causes the private sector to contract by .6%.

They also suggest that spending cuts are less damaging than tax increases, but note that this is only relevant for countries who are having fiscal debt issues (like Greece) and can lower interest rates by reducing spending. This clearly doesn’t apply to the U.S. Even with our blown out Federal deficit and the S&P downgrade, the international bond markets have shown their unflinching confidence in U.S. debt. As the markets continue to gyrate wildly, the rate of return on a 10-year T-bill simply continues to fall.

To sum up, one of the biggest issues in the U.S. economy is the sniping between the two parties on the issue of tax cuts and Federal spending. On tax cuts, both parties are wrong. All the tax cuts put into place by both Bush and Obama are doing as much to stimulate the Chinese economy (if not more) as our own by simply keeping the trade gap unsustainably high. And it surely hasn’t helped those ‘job creators’ create more positions given that job growth over the last decade has been tepid at best. Ultimately the cuts are only enabling Americans to continue to overspend—a bad habit that started during the housing boom that dominated the economy over the past decade.

Its time to recognize the failure of these policies as a cure for the U.S. economic doldrums. Instead they are simply building up a painful amount of Federal debt that will eventually need to be reckoned with. As for spending, this money would have been much better used as direct funding for infrastructure projects, and perhaps tax credits for small business investments and hiring. This would be spending that directly affects U.S. production.

Be prepared. Eventually the U.S. is going to have to come down off of its Federal debt stimulant—and it is going to be painful. We only hope that our two major political parties can stop bickering over pointless debates and start working on real solutions to get the economy to a point where it can handle these painful future adjustments.

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