Tax cuts are good for economic growth, or at least basic economic theory tells us so. Take a look at the meticulously designed diagram at the top of this article, which I made in a free edition of the Paper app.
The diagram shows how an economy functions. In this example, households spend disposable income on goods, stores use that money to spend money on inventory, factories use it to buy business related products and services, those companies use the money to employ owners of households and the circle continues on. Disposable income = Income – Taxes – Savings.
With this understanding, if taxes are decreased, then, holding all else constant, disposable income is increased. When disposable income is increased, one assumes, consumers will increase spending, as do all others in the “economic chain” so to speak, causing an overall gain in economic growth. This is why tax cuts are considered good for economic growth. The notion of holding all else constant, however, ignores the concept that people are rational economic entities, capable of foresight.
When tax cuts are funded by debt, people are aware the debt must be paid for, at some point, in some way. This reality is a signal for future tax increases and, as defined in our model above, a future decrease in disposable income. This signal for a future decrease in disposable income, decreases one’s likelihood to spend their new-found disposable income, or as economists put it, decreases their marginal propensity to consume. Rational entities save the new disposable income, in order to supplement future decreases in disposable income.
The problem is exacerbated when business entities are deciding on long term business investment. Signals of future tax increases lead to an uncertain and risky business environment, in which businesses may hoard cash, or settle for safe below market returns, instead of investing in the future. This is most likely one of the reasons why people keep investing in US Treasury Bonds and why businesses are hoarding cash both domestically and abroad in record numbers.
Politicians have favored temporary tax cuts, as a way to micromanage the economy and to manipulate government projections for the tax break’s effect on future deficits. Recent temporary tax cuts, which have been funded entirely by new debt, are as ineffective as stimulatory economic policy can be. They are designed to only be in effect for a small time and directly add the government deficits. A 65 year study conducted by the Congressional Research Service, has found income tax cuts to top earners to have “little to no effect” on economic growth.
I am not saying tax cuts are bad for the economy, nor that temporary tax cuts are bad for the economy. I am saying they may be ineffective, if funded entirely by debt, with strong signals of future tax increases. For tax breaks to deliver real economic benefit, they must come from a fiscally responsible government or(and) subsequent decreases in government spending.