Tuesday, November 23, 2004

Tax Cut Article - Part 3 of 5

Where the Bush Tax Cuts Effective?

Part of the student's original question was "...would you say President Bush's tax cuts were ineffective because of the deficits they created?"

The idea behind the supply side type tax cut that President Bush signed into law is that marginal tax rates are too high and these high rates discourage discourage people from increasing their incomes by working more. The idea is to reduce the rates to encourage more work which means more income is earned and that increases the amount of income available to tax. In theory the increase in income due to the tax cut will be proportionately larger than the percentage reduction in tax rates so the new, smaller tax rates times the new higher incomes will produce more tax revenue. As an example, ten percent of $100 is $10 while 8% of $150 is $12. In this example the smaller rate against the larger base resulted in a larger amount collected ($12 rather than $10).

There is a lag between the passage of the tax cut and the time the people adjust their work hours. Once a tax cut law is passed people see that they can keep more of the extra money that they earn and are then more receptive to additional work. But actually increasing work hours takes time. When companies have the need for overtime work they will find employees more willing to volunteer for such work. Also, some people will begin looking for part-time jobs to supplement their incomes, stay at home spouses will find it advantageous to return to work, and high income professionals will find it profitable to increase their service offerings.

Ronald Reagan used to tell the story about when he was a movie actor he found that he could live very well doing five movies per year. But if he did a sixth movie it pushed him into a higher tax bracket and most of the additional income from the sixth movie went to taxes. So he limited himself to five movies per year. It was not just Reagan's income from the unmade sixth movie that was lost to the IRS but also the incomes of all the other minor actors and support people – people whose incomes were much less than that of the star, Reagan, and who wern't faced with losing most of the extra income to the IRS but they, and the IRS, lost out on that extra income because the sixth movie was not made. Multiply this by all the high paid actors, lawyers, doctors, etc. who deliberately limit both their hours and the hours of their staffs and you can see that large amounts of income are not being made and thus, not available to be taxed.

Initially taxes are cut and the tax base, or total income being generated by taxpayers, remains the same so tax revenue falls. To avoid a deficit, the government should make a corresponding reduction in spending but this never happens. Remember, this was the reason the Republicans originally opposed the Kennedy Johnson tax cut was fear of the deficit. But, once the tax cuts take effect and people have time to adjust, incomes increase and this results in a larger tax base which generates the revenue to remove the deficit.

That is the theory. There is a caveat and that is that the politicians cannot be allowed to increase spending to match the increase in revenues. Government's are like my children, they can't resist the urge to spend all the money at their disposal. In the case of my children the cost of lunch in school is three dollars, but if I only have five dollar bills when I drop them off at school they manage to spend the entire five rather than bringing home the change.

The Kennedy Johnson tax cut increased revenues but, in addition to the tax cut which caused a short term deficit, President Johnson also enacted the very expensive Great Society program AND attempted at the same time to finance both the Vietnam War and the Cold War. This was too much and massive inflation followed.

Ronald Reagan's tax cut resulted in a short term deficit but he fought hard to keep spending in line and was aided by this with the Gramm-Rudman-Hollings law which required Congress to find money to pay for new programs before they could enact the programs. The result of the Reagan tax cut was over a decade of economic growth, low inflation and a budget surplus (which has since been spent by his successors).

There is reason for concern about the deficit with President Bush. Unlike Reagan, whoes philosophy was "The government is the problem" and sought to reduce government spending, President Bush's compasionate conservatism tends to see government spending as a problem only to the extent that it is not being managed responsibly. President Bush does not seem to be philosophically opposed to big government and big government spending per se.

The tax cuts are starting to increase revenue as expected. But there is anger and concern among many of the President's supporters because of his tendency to approve big spending items like the Medicare Prescription Drug law, the No Child Left Behind Act, etc. all of which represent huge increases in spending. Some of his supporters give him the benefit of the doubt by saying that he included free market incentives in the laws such as the Health Savings Accounts in the Medicare bill and the accountability rules in the NCLFB act and that the increases in spending were required to get these needed structural reforms passed. We will have to wait to see how he handles spending in his second administration before we can conclude whether the initial deficit from the tax will be a problem or not. But regardless, the tax cut is generating economic growth and the revenue to eliminate the initial deficit. The only question is will the administration and Congress use the money to eliminate the deficit or go on a spending spree.

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