Wednesday, November 12, 2008

The Economics of Tax Cuts

In the political world, we often hear a clamour for tax cuts. Tax cuts are often presented as a solution to many economic problems, and of course, they are popular with the electorate. But, what is the economics behind tax cuts. Will tax cuts really boost economic growth? will tax cuts boost productivity?

Tax Cuts and Aggregate Demand

It is often argued tax cuts will boost spending and help recover from recession. If you cut income tax, people see an increase in disposable income and therefore, in theory spend more.

But, how much will spending actually increase?
  • If confidence is low. If people want to increase their savings, (this usually occurs in a recession when people fear unemployment) then tax cuts may not be spent but saved.
  • Depends on Tax Cuts. People on low income have a higher propensity to consume. If you cut taxes for those on low incomes there will be a bigger impact on increasing spending. If you cut taxes for high income earners, a higher % will be saved.
  • Borrowing could cause crowding out. Ultimately tax cuts have to be paid for. In the short term, it requires higher government borrowing. Some argue that if the government borrow, the private sector buy more government bonds and so have less to spend and invest. Therefore, the tax cuts could be outweighed by a decline in private sector investment. Furthermore, increases in national debt, can push up interest rates as the government need to attract more people to buy bonds.
  • The problem with cutting taxes to boost demand is that politicians 'forget' to reverse them during an economic boom. This is why the US national debt has passed $10 trillion. In a recession, there is always a call for tax cuts to boost the economy. But, as the economy grows quickly, there is no call to increase taxes, to reduce debt and stabilise growth.
  • Tax cuts will help to increase growth a little, but, direct government spending on public works will have a greater impact on boosting aggregate demand.
  • It does makes sense to cut taxes in a recession, as long as you increase them in a boom. The problem is that because national debt is already high in UK and US, there is little room for future tax cuts.
  • There is a debate at the moment whether Gordon Brown is right to cut taxes and borrow more to stimulate the economy - see: Tax cuts now could mean tax increases tomorrow at independent

Do Tax Cuts Increase Productivity?

  • The famous Laffer curve suggested tax cuts will increase productivity and could even increase tax revenue. The simple argument is that lower income tax increases the incentive to work.
  • However, in economics there is both a substitution and income effect. To simplify. If you have a target income of £30,000. a tax cuts means that you can get this income by working less hours. Therefore, this income effect outweighs the substitution effect.
  • Basically, studies show that cutting income tax rates in the US, had little if any impact on increasing labour productivity.
  • However, if income tax rates were 50 or 60% then there there is likely to be a disincentive effect. But, cutting tax rates from 22% to 21% will have little impact.

Do tax cuts make us better off?

America has lower income tax than Europe. But, Americans have additional expenses in the form of private health insurance. Lower taxes are a false economy if you then have to spend more on private health care and higher education e.t.c

No comments: