Sunday, January 27, 2008

Advantages of Tax Cuts

Readers Question: What the benefits and the negative effects of reducing all taxes?

The idea of cutting all taxes is key element of libertarian politics. Cutting taxes is often a mantra repeated by conservative parties, although in practice, they usually find it more difficult to cut taxes than their rhetoric would suggest.

Firstly Cutting all taxes has an opportunity cost it requires either:

  1. Cutting Government Spending

  2. Increasing Government Borrowing

Of the two, cutting government spending, is the only policy which is sustainable in the long term.

Benefits of Tax Cuts

  1. Government inefficient. It is argued the private sector is more efficient in spending money than the public sector. Government spending tends to be wasted, with high bureaucracy costs.

  2. Lower taxes can increase incentives to work. It is argued lower income taxes will encourage people to work longer hours and new people to enter the labour force. Lower corporation tax will encourage firms to invest in the country.

  3. Laffer Curve. It is even argued that cutting taxes can even increase government revenue. This is because if taxes are too high people don't work, so don't pay taxes. However, if people do work more, the government can actually gain more revenue.

Problems of Tax Cuts

  1. Difficult to Cut Spending. The main problem that governments have faced when in power, is that cutting spending is actually very difficult. When you are in opposition it is very easy to say that their are too many 'benefit seekers'. It is easy to say, the government spend too much money. But, when you actually try to significantly cut spending it proves much more difficult because it will annoy some group.

  2. Increased Inequality. Cutting taxes can also lead to the danger of increasing inequality because a lot of government spending is targeted to lower income groups. It also depends on the type of tax cuts.

  3. Cutting Taxes rarely increases incentives. The Reagan administration hoped cutting income tax would stimulate supply side improvements, in practice it caused an increase in government borrowing. If you cut income tax, people don't necessarily work more (there are 2 effects: the income and substitution effect at work)

  4. Taxes can be used to discourage spending of demerit goods. E.g. taxes on alcohol and cigarettes can be useful for discouraging their consumption.

  5. Lower Taxes can lead to higher cost elsewhere. Generally, the US has a lower tax burden than the Europe. However, although Americans have lower taxes they have to pay for private health care insurance. However, they are also paying a profit margin to private companies. The Americans spend more on health care than any other nation, but, they have still patchy coverage. I would suggest that America should increase taxes and pay for health care from government spending - it would be more efficient and equitable.


Can Tax Cuts avoid Recession
Should taxes on Cigarettes be Increased?

1 comment:

Anonymous said...

A tax induced distortion in economic behaviour results in a net efficiency loss to the whole economy- even if the government engages in exactly the same activities as the private sector would have, with the tax revenue so raised.