Fiscal Policy Part 1: Do Tax Cuts Pay for Themselves?

The economic news of the day is centered on the Republicans’ tax reform bills becoming law, and what their effects will be. Rather than debate over political lines about the pros and cons of this particular piece of policy, I want to take this opportunity to address certain aspects of Fiscal Policy as a whole. As a reminder, Monetary Policy refers to policy from the Federal Reserve, such as changing the supply of money, bank reserves, and interest rates. Fiscal Policy, on the other hand, comes from the Federal Government, in the form of the tax code and government spending/borrowing. This set of posts will focus on the latter, starting with the backbone of tax plans: do they pay for themselves?

The chief argument for cutting individual taxes is thus: The Federal Government is inefficient and takes money out of the private sector that people could use to benefit themselves if they were allowed to hold on to it. If people were allowed to keep more of their earned income, they could spend it on additional goods and services, or invest it and be more financially stable. The argument for cutting corporate taxes is roughly the same, that if businesses were allowed to keep more money that they earned, they could invest it in better equipment or more workers, boosting nationwide GDP. This boosted GDP would in turn create more tax revenue because of the broader ‘base’ of taxpayers (additional corporate entities, more individuals in the workforce) and would offset the initial loss of revenue created by the cuts.

To its credit, this theory does come from sound economics. In the Keynesian business cycle, the economy digs itself from out of a recession by deficit spending, and a way to do that is by cutting taxes and giving people more money to spend. Spending more money on goods and services incentivises businesses to produce and hire more, and the growth that comes from that would restore the economy to normal levels.

On a static basis, the answer to our question is a resounding No. Cutting taxes does not lead to additional tax revenue. Pretty self explanatory really. But proponents of this kind of Fiscal Policy would prefer it be judged on a dynamic basis, that is, a basis that takes into account the effects of additional growth.

I should tell you now that, if you’ve read my last write up on the business cycle, you would know that I do not think producers have as significant an effect on spending as consumers do. By extension, I do not think that cutting business taxes stimulates higher economic growth. But facts are more important than opinions, and there is data we can look at to see how our original question can be answered. Logically, the only way a revenue-negative tax plan can pay for itself is through more taxes taken in from additional economic activity.

I have provided some data links at the bottom of this page that show GDP growth for certain years at certain corporate tax rates. A common political talking point is that GDP growth used to be a lot higher than it is now, and that we can get back to those levels if we cut taxes. Looking at the data, we see that GDP growth was highest when we had higher tax rates, with tax rates in the 80s and 90s, and the change in GDP has generally gotten smaller over time. A longer, future article will delve into this trend in much more detail, but suffice it to say for now that GDP growth is not and should not be the end all measurement for economic performance as it relates to tax policy, as it is influenced by many different factors having nothing to do with taxes, and that the downward trend of GDP growth is part of a larger theory on developed nation performance and is looked at too negatively.

The data still does show that at a higher marginal tax rate, especially for businesses, GDP does tend to gain higher. Surely that could not be the case, if those businesses were better handlers of their money than the government and could stimulate growth in a better way? Again, a further article will explore another growing trend, but in recent decades, higher corporate profits have translated into stock buybacks and higher management compensation more so than higher wages and increased investment.

Having established that GDP growth is on a low and predictable decline (for several good reasons), the only way for tax cuts to pay for themselves would be through similar cuts in government spending. Without getting bogged down in the political weeds, I will simply say that the government ran a $676 billion deficit last year, and the national debt recently crossed $20.5 trillion this year. The most recent tax cut plan will assume just over $1.4 trillion in additional debt over 10 years, so $140 billion a year. Democrats and Republicans both have spending items they want to see shrunk and spending items tbey want to see expanded, and I do not see this number shrinking too much in the near future. Additionally, as tax revenues shrink and spending does not, the government will need to borrow more, and issuing more government bonds will raise the effective interest rate on those bonds. The government will have to pay more in interest as a consequence. If you want to track where the debt is, I have included the website on the bottom of this page.

But doesn’t tax policy have any effect on GDP? The answer is yes, through not as much as proponents of cuts would have you believe. Taxation takes money away from the Consumption function of GDP, shown as 1-T = C. The bigger T is, in theory, the smaller C can be. However, the corollary theory would show that making T smaller does not necessarily increase C by a proportional amount. This is the Marginal Propensity to Consume function, defined as MPC = N, where N is a number between zero and one. If N is 0.5, then for every additional dollar a consumer earns, he will only spend 50 cents. Every consumer’s MPC is different, and it is nearly impossible to map a constant MPC for an entire population, but the point of this function is to show that an additional dollar saved does not equate to an additional dollar spent. As wages continue to flatten and costs continue to rise, I expect to see most consumers increase their propensity to save, and decrease their propensity to consume.

These are just a few of the things that need to be looked at if policymakers want to make sure that cutting taxes leads to increased tax revenue. I think, based on the information I have gone over, that the answer is no, they do not. This page is the first of a series on Fiscal Policy, and you can expect more soon!


Categories: Economics - Fiscal Policy

6 replies

  1. Your comment – money saved on business/personal taxes will result in more in business savings/profits and consumer saving – not spending – I think is RIGHT on the mark.


  2. Nice work Ian. Look forward to reading the next installment.


  3. Good stuff Ian.
    I would add – one way to cut government spending would be on their salaries and extracurricular cover ups, etc.
    Look forward to the next write up.

    Liked by 1 person

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