Friday, December 10, 2010

Flaherty welcomes U.S. tax cut deal - The Globe and Mail

Flaherty welcomes U.S. tax cut deal - The Globe and Mail

The link is to a Globe and Mail story in which Finance Minister Flaherty explains his belief that tax cuts stimulate spending. This is a common argument made by neo-liberals but does it hold up? The argument that tax cuts increase consumer spending which is good for the economy is, in fact, so taken-for-granted that I can't recall ever have seen someone question it in the regular media. To Flaherty's credit, he does not that tax cuts for the rich don't work nearly as well, in theory, as tax cuts for the poor in order to increase spending and you can see why. Poor people are not having needs met and so lowering their taxes clearly does produce more spending on their part because they need to spend. The rich, on the other hand (and not, I'm not being to specific in the way I am describing social classes) already have their needs met and more. Cutting their taxes -- giving them more money -- therefore will likely not increase spending because they don't need to spend.

But, the first question I asked is a good one, don't you think? Surely, there should be some evidence that tax cuts can increase spending and hence improve the economy because everyone says it and no one questions it so if someone knows of an empirical study that demonstrates this, please send it to me.

I'm not trying to be an idiot here. In theory, I can't figure out why tax cuts would increase spending and improve the economy. Imagine, for instance, you sell computers. A tax cut allows people to buy more computers and you are happy with this. More orders means you need to hire more staff and can spend a bit more on Christmas presents for the kids, etc. But, should not the same principle apply regardless of who is buying your computers. For instance, imagine that the school system wants to buy a bunch of computers for their students. This is state spending. Now, if you own the computer shop, what do you care who buys your computers. It makes no difference to your bottom line whether I buy them as a private citizen or the school board buys them. In each case you have more sales and the amount of money you've earned is the same. It seems to me that if consumer spending is to have a positive effect on the economy, that spending must be greater then the amount that would have been spent by the state because the state cannot spend money it does not have. If you cut taxes -- to increase consumer spending -- then the level of state expenditures will go down.

Let me give you a really simple example. Let us imagine that I have an income of $1000.00 and I pay $100.00 in taxes. That gives me a total amount of money to spend that equals $900.00. The state takes the $100.00 from me and uses it for all kinds of things (including buying computers for schools and paying doctors). Now, imagine -- just as an example -- that I spend all my $900.00. This means that I have spend $900 but the $100 in taxes did not disappear. It was spent, too (on computers and doctors). Now, to continue this example, imagine that someone wants to decrease taxes to increase my income in order to stimulate the economy. So, I get a tax cut of $25. I now have $925 to spend. But, overall spending has not increased, has it? The state no longer has $100 to spend but $75 so the total level of spending is the same: $1000.00. In theory, then, a tax cut will not increase spending and so cannot stimulate the economy because the total amount of money being spent is exactly the same as before.

But, it could get worse, couldn't it. My model is really simple. What happens if we add in issues like saving (imagine I don't spend all my tax cut, then the total level of spending in society would actually decrease because I saved money!) or overseas investment: what happens to the Canadian economy if I take some of my money and invest in ... oh, I don't know ... oil in Russia. That might be good for Russia but how would it help Canada? In the case of saving or overseas investment, a tax cut could produce ironic effects, couldn't it. It could decrease overall spending and hence hurt the economy.

There are a range of other issues to consider as well. What about the inflation rate? If the tax cut increases my income by less then the inflation rate ... what is the overall effect?

In short, I cannot figure out why tax cuts would increase overall spending in the economy. Businesses don't care who buys their goods as long as someone buys them. The effect is the same regardless of whether Bob or I or Stephen Harper buys them.

Here is what I think. This argument - tax cuts will increase spending -- works because people assume state spending will remain constant. Instead of cutting spending when I got my tax cut to $75 dollars (laying off workers and hurting the businesses from whom they bought things), I think most people assume that the government will continue to spend as before. And, in the short term, this might be possible through borrowing. But, and here is the kicker, in the long term, it is just not possible.

There may be reasons to cut taxes. Nothing I have written indicates that a good argument to cut taxes cannot be made. It does suggest, however, that we need to think again about the standard rationale given for tax cuts because it just doesn't make sense.
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