Can Tax Cuts Stimulate the Economy?

It has long been held as an element of Republican truth that tax cuts stimulate the economy. Is this valid? If so, why? If not, why not?

In today's Washington Post, Fareed Zakaria argues that Mitt Romney's proposal to cut taxes to "reward job creators, not punish them" is mistaken:

(Romney) tells us that on his first day in office — after approving the Keystone XL pipeline — he will “introduce tax cuts . . . that reward job creators not punish them.” The one idea that is almost certain not to jump-start this economy is a tax cut.

Why can we be sure of this? Because that is what we have done for the past three years. For those who think President Obama’s policies have done little to produce growth, keep in mind that the single largest piece of his policies — in dollar terms — has been tax cuts. They actually began before Obama, with the tax cut passed under the George W. Bush administration in response to the financial crisis in 2008. Then came the stimulus bill, of which tax cuts were the largest chunk by far — one-third of the total.

Zakaria is correct that tax cuts today won't do much to help the economy, but he fails to explain why. He simply points to the fact that they didn't work in 2009, and implies that expecting them to work now is akin to that cliche about the definition of insanity. That is a pretty weak argument, because it assmes that conditions now are the same as they were then.

Zakaria goes on:

And the nonpartisan Congressional Research Service concluded in 2010 that “by almost any economic indicator, the economy performed better in the period before the [Bush] tax cuts than after the tax cuts were enacted. . . . GDP growth, median real household income growth, weekly hours worked, the employment-population ratio, personal savings, and business investment growth were all lower in the period after the tax cuts were enacted.” The years 2000 to 2007 were the period of the weakest job growth in the United States since the Great Depression.

All of these statements are factually true, and cannot be argued against reasonably.

Why won't tax cuts spur the economy? The simple answer is that there's no shortage of money. The problem is not that people lack money to spend; the problem is that they lack the desire to spend.

All that a tax cut would do is give people more money to hoard. Economically speaking, this would increase the deposits in banks and investment accounts, making credit more widely available and pushing interest rates even lower.

What is killing the economy right now is uncertainty. Small businesses can't figure out how much a new hire will cost them under Obamacare. Others see changes occurring to the myriad of EPA red tape that they were just starting to figure out and rightly think, "now what?" Never mind the mystery of the future of the Bush tax cuts or the payroll tax holiday.

People can't make long-term plans right now. The inability to plan means there's a risk premium attached to every decision. That means that even tiny risks are magnified, and only investments with obvious and early returns are made. Long term investments are killed by this kind of uncertainty.

No, tax cuts do not automatically stimulate an economy. They only stiumulate the economy when a shortage of cash is what is holding it back. Instead, here are some things that would produce real stimulus to the present economy:

1. Change the Fed's mandate to price stability only (instead of price stability and unemployment both). The Fed could then ease the money supply to get nominal GDP back on track. Monetary policy is too tight.
2. Streamline and simplify the tax code. Too many credits, subsidies, deductions, and schedules make compliance confusing and onerous-- and make tax collection very inefficient. We can both reduce the tax burden people feel AND increase revenue to the Government if we scrapped most of our awful tax code designed to manipulate people's behaviors rather than finance the government. Even if we don't get all the way to the Fairtax, any national consumption tax that lacked a ton of credits and subsidies and writeoffs would be a huge improvement.
3. Announce a freeze on EPA rulings and regulations.
4. Announce a freeze on the Federal Budget, where the Federal Gov't will spend the exact same amount 3 years in a row, fixed at 17% of GDP.
5. Repeal Obamacare and replace with a state-based system based on free association and competition.
6. Limit unemployment benefits to 6 months. These benefits are not free-- they are funded by a tax on businesses, and are particularly onerous to small business.

 

 

Comments

[J. Hohn]

Sorry for the typos in this one. Looks like I hit the "post" button a little too early.