Monday, February 18, 2008

Will the US economy Really Benefit from Tax Cuts?

It is interesting to see the almost unanimity across the American political spectrum about the need for tax cuts. Americans seem to talk of tax cuts so frequently it is surprising they still have any taxes left to cut.

These are some of the benefits of Cutting Taxes:

1. Expansionary Fiscal Policy.

With falling house prices, there has been a marked slowdown in consumer spending, this could lead to recession and rising unemployment. Therefore, the main reason for the current tax cuts, is the necessity to increase consumer's disposable income and boost economic growth. This is good old fashioned Keynesian demand management. Although Bush, may not label himself a Keynesian (I wonder if he knows what a Keynesian is) that is precisely his philosophy.

2. Increased Incentives to Work.

It is argued that lower income tax and lower business tax can encourage people to work longer hours and business' to invest. It is a simple argument that if wages are higher they will substitute leisure for work. However, despite many people trying to exaggerate the importance of this argument, there is little empirical evidence that tax cuts do actually increase incentives to work. If income tax was over 60%, I think tax cuts would increase incentives, however, with income tax at current levels, cuts in the basic rate would have little effect. (this is partly due to the income effect, with higher wages, people can work less and earn their target income)

3. Boost Confidence.

Stock markets are falling on forecasts of a recession. Cutting taxes increases confidence that the economy will avoid a recession.

These are the main arguments for tax cuts, but, are they really any good in practice.

Arguments against Tax Cuts

1. Demand can be managed by Monetary Policy.

With the Fed cutting interest rates by 1.25% in the space of a few weeks, is there really any need for an expansionary fiscal policy as well? It could be the case the US economy is stimulated too much, causing inflation.

2. The American Economy is Unbalanced

The American economy has long been skewed towards relying on consumer spending to boost growth. This has resulted in record low savings ratios, high current account deficit, record levels of consumer borrowing and excessive risk taking. By cutting tax, the government is trying to mask the underlying problem without solving the causes of the weakness. Although, it may cause lower growth, America may need a period where consumer spending takes a lower priority. This would help reduce the current account deficit, boost the savings ratio and stimulate long term investment. It is even argued that the reflationary fiscal and monetary policies can be seen as pandering to the bad economic decisions of reckless borrowing and investment.

3. Government Borrowing.

US national debt is currently 65% of GDP (under $10,000 billion). In a downturn, we expect borrowing to increase and get worse; however, with such a large fiscal deficit, the government should not be so keen to exacerbate the deficit more than necessary.

4. Will Confidence really be restored?

It is a matter of debate whether a tax cut will really restore confidence. The expansionary measures have a touch of panic about them. The consumer may feel that prospects for growth are still low, and therefore, they will choose to save the tax cut making the expansionary fiscal policy have little effect.

5. Tax Cuts will not solve the problem in the Housing Market.

The real problem facing the US economy is the defaults from the subprime crisis and the problem in the housing sector. These problems will not really be solved by cutting income tax. The cuts in interest rate will have the biggest effect on easing mortgage interest repayments.

Problems with US Economy

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