Saturday, November 20, 2004

Tax Cuts and the Economy - Part 1 of 5

The following question was received from one of the students in the Economics 200 course:

From an economist's perspective, would you say President Bush's tax cuts were ineffective because of the huge deficit they created? Also they haven't seemed to stimulate the economy that much or create many more high jobs and the cuts were done during a war?

Here is my reply to this student:

This is a very good question. However, your question has three parts and I will answer each in a separate article. The three parts of your question are:

1. The budget deficits that resulted from the tax cut

2. The amount of jobs created as a result of the tax cut.

3. The quality of the jobs created.

The first thing to keep in mind is that tax cuts are as much political as economic, meaning that the President and Congress are just as concerned, if not more concerned, about the political as the economic effects of a tax cut. There are two main economic theories behind tax cuts: the Keynesian theory and the Supply Side theory. There are also two main political motivations behind tax cuts: increase government control of the economy or reduce government control of the economy. The economic theories are not necessarily mutually exclusive as was demonstrated when President Bush and some of his supporters used both Keynesian theory and Supply Side theory arguments when arguing in favor of the tax cut plan. The political motivations, however, are mutually exclusive in that the motivation must be for either increasing or decreasing the size of the government as you cannot do both at once. It is the political motivations behind tax cuts that divide Republicans and Democrats.

Let's start with the economic rationale for tax cuts and look at the two theories behind them.

The first theory is the Keynesian theory which views tax cuts as a counter cyclical tool of fiscal policy. Keynes focused his theory on demand and viewed demand as the key to managing the economy. Writing during the Great Depression of the 1930s, the problem Keynes saw was an economy faced with massive unemployment of both labor and the other factors of production. The problem, as Keynes saw it, was inadequate demand – people were out of work and and their purchasing power was sevearley restricted. With sales slow to non-existant, employers could not afford to hire people if there was no one to purchase their product. Classical theory stated that, in a free market, prices would fall to the point where people could afford to purchase the goods and wages would also fall to where employers could afford to begin employing people again. As the economy expanded wages would begin to rise as employers were increasingly forced to lure additional workers with the promise of higher wages. But the 1930s were not an era of flexible wages and prices. The economy was heavily unionized and union contracts would not allow wages to fall. Similarly, cartels existed in many industries and these acted to limit output and maintain price floors. Since normal free market mechanisms were not working, due mainly to unions and cartels, Keynes felt that the only way to pull the economy out of the depression was for the government to move in and act as the catalyst to get the economy going again (actually, it was government policy that provided the unions and industrial cartels with the power to enforce the wage and price floors). According to Keynesian theory, when the economy was in a recession or depression the government was supposed to step in and increase demand by:

1 increasing government spending (on things like building roads, public buildings, etc.) while not increasing taxes;

2 by cutting taxes while maintaining current spending levels; or,

3 a combination of increasing spending and cutting taxes.

Any one of these three courses of action would mean that the government was spending more than it collected in taxes and this would result in a budget deficit. But deficits were the goal of this policy as the objective was to keep government spending level or increasing while also increasing consumer spending.

Supply side theory stresses the need to increase supply by growing the economy. Modern supply side theory came into vogue during the 1970s and 1980s when the economy was expanding and demand was exceeding the economy's capability to produce goods and services to meet the demand. The problem was inflation, not depression. According to the theory, tax cuts were needed not so much to stimulate demand as to grow the economy. It was felt that tax rates were such that they were discouraging investment and work. Economist Arthur Laffer developed a curve showing that as marginal tax rates (see the October 10th posting on the Progressive Income Tax) increased they reached a point where they discouraged additional work and investment. By reducing the high marginal income tax rates government would let people keep more of the additional money that they earned – i.e., overtime income, income from a second job or income from a spouse going to work. People have to put forth a certain amount of work in order to support themselves, but, they will only work additional hours (overtime, second job, spouse going to work) if they see some reward in it. If the government taxes away most of the additional income people will have no incentive to put forth the extra effort. When existing workers work longer hours it is the same, in terms of production, as increasing the number of workers. For example, if ten people accept overtime assignments of four hours per week each (i.e., each worker works their regular 40 hours per week plus 4 hours of overtime) this is the same as adding one additional worker to the labor force. If one million people work an additional four hours per week that is the equivalent of adding 100,000 workers to the labor force – you can see that this could increase output substantially.

Note that after point 'X' on the graph, additional tax increases result in REDUCED revenues. If you are in the area to the right of point 'X' then REDUCTIONS in tax RATES will result in more revenue. But if you are to the left of point 'X' then reductions in rates will result in reduced revenues for the government.

In the next posting I will discuss the politics behind tax cuts.

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