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Is a Tax Cut Always a Good Thing?

Posted By Salim Furth, Ph.D On October 30, 2012 @ 12:33 pm In Economics | Comments Disabled

According to Friday’s Washington Post [1], the Administration is considering a new, short-term tax cut. Should conservatives cheer?

As a matter of principle, there are at least two reasons to dislike taxes and to applaud tax cuts. First, taxes take money away from those who made the money in the first place. For reasons of basic morality, democratic governments should respect individual property rights as much as possible while meeting their constitutional obligations.

Second, most taxes create a disincentive to invest and work. If people work less, present production slows; if people save and invest less, future production is hamstrung.

Given the enormous debt owed by the American government, to justify a tax cut today, it must be clearly and powerfully effective. We should demand well-designed tax cuts that get the most bang for our buck. Tax cuts that give money back to people without changing incentives might sound good, but they will have no stimulative effect today and most likely lead to higher future taxes, which will increase the disincentives to work and invest and slow future growth.

Economists of all stripes agree that short-term tax cuts or rebates have little effect on incentives. Even paleo-Keynesian Paul Krugman [2] wrote critically of the 2008 tax rebates. Although these short-term measures return money to those who made it, they leave the economy indifferent in the short run and obviously do nothing to help growth in the long run.

Why don’t short-term tax cuts help long-run growth? Because long-term growth is determined by investment and technological change.

How about the short run? Don’t demand-side “stimulative” policies like rebates and the payroll tax cut boost the economy in the near term? According to Keynesian [3] theory, a consumer receiving a rebate might go out and spend the money on shoes, then the cobbler would spend his extra income at the grocer, and the grocer would spend her extra income at the glazier [4], and so forth.

But this is a remarkably naïve approach, since it never asks where the original money came from. Critics note that the government can pay for the rebate only by borrowing money from the banker, who then lends less to the cobbler, who thus buys less from the grocer, and so forth.

Fairy-tale economics works only when you tell half the story.

Let’s look back at the 2008 tax rebates. After the rebates were issued, several economists tried to measure whether people had spent most of the money they received. While the evidence [5] is mixed [6], everyone agrees that at least some of the rebates were spent. All that extra spending should show up in aggregate consumption figures, right?

John Taylor looked in 2009 at the aggregate measures of disposable personal income and personal consumption expenditures. There’s an unmistakable jump in disposable income in May 2008. But consumption doesn’t budge. If rebate recipients spent some of their rebate, there would have to be an increase in aggregate consumption, wouldn’t there?

No—not if the consumption increase by those receiving the rebate was offset by a decrease in spending by those who funded the rebate. Thus, the data show exactly what modern economics teaches us to expect: The rebate is just a transfer from lenders to present taxpayers, and future taxpayers are left with the bill.

To be fair, the tax cuts floated by the current Administration are not very different from those pushed by the Bush Administration, first in 2001 and again in 2008. A short-term tax cut would be nice for those who receive it, but we should not expect it to “stimulate” the economy at all.

And in an environment of dangerously high deficits and debt, future taxpayers should demand that every tax cut get the maximum bang for its buck. Short-term tax cuts would not increase investment and employment, but they would increase the deficit. That’s not good enough.

Instead of more short-term fiddling, the Administration should work with Congress to provide a long-term solution to the $500 billion in permanent tax increases scheduled for January 1, 2013. A credible, long-term deal that keeps tax rates low and brings debt under control gives the best chance for the economy to finally experience a full recovery from the 2008 recession.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2012/10/30/is-a-tax-cut-always-a-good-thing/

URLs in this post:

[1] Friday’s Washington Post: http://www.washingtonpost.com/business/economy/white-house-considering-new-tax-cut/2012/10/26/8187d726-1fa5-11e2-9cd5-b55c38388962_story.html?hpid=z1

[2] Paul Krugman: http://homes.chass.utoronto.ca/~gindart/2008-01-25%20-%20Stimulus%20gone%20bad.pdf

[3] Keynesian: http://www.investopedia.com/terms/k/keynesianeconomics.asp#axzz2AnX6kXen

[4] glazier: http://mises.org/daily/3804

[5] evidence: http://papers.nber.org/tmp/93356-w16684.pdf

[6] mixed: http://www.nber.org/chapters/c11972.pdf

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