Tax cuts

by Daniel Hekman

Created on: May 13, 2010   Last Updated: May 14, 2010

The question of proper fiscal policy is an extremely complex and convoluted question with many facets. Even excluding issue of voter opinion that constantly plagues politics and causes politicians to vote for policies that are, in the long run, counter-productive, this question does not have any easy answers. The reason for this is that any change in fiscal policy necessarily has multiple effects that work in opposite directions both in the short run and in the long run, and the "stronger" effect is often unknown in advance.

Before I begin unpacking this topic, I would like to first provide a brief introduction to the central identity in macroeconomics:

Y=C+I+G+NX

In English, this means that Gross Domestic Product (GDP) is equal to consumption spending + investment spending + government spending + net exports (i.e. total exports less total imports).

Consumption spending is all consumer spending, including cell phones, food, music, etc. Investment spending is done by firms when they decide to build and open a new factory; it also includes spending on residential housing.

Government spending is a little tricky: it includes all spending done by the government on things like roads, civil servant wages, etc., but does not include things like Social Security and Medicare, which are transfer payments.

Lastly, net exports is simply all the goods services produced domestically and then sold in foreign markets minus all the goods and services produced abroad and imported.

Back to fiscal policy: in economics terminology, the two most prominent effects of changes in fiscal policy are known as the "income effect," and the "crowding out effect."

The Income Effect refers to the phenomonon that when people feel richer, they spend more. This may seem obvious, but there are several notable corollaries.

First of all, the word "feel" is important. Feelings of being richer can result from obvious things like getting promoted or getting a pay raise, but also from more transient things like the stock market rallying.

Secondly, in economics, savings are considered a normal good that one purchases-typically in the form of stocks, bonds, or money market funds-so as income rises, people also save more.

The Crowding Out Effect is the fact that when the government borrows money, it is effectively competing with firms to do so. This means that interest rates must rise (in response to increased demand for loans) and it makes investment spending  on the part of firms more expensive.

This is incredibly important because investment spending ('I' from the equation above) is the most volitile component of GDP and also the biggest indicator of future economic growth.

So, how do these effects show up in tax policy? For the entirely arbitrary reason that "tax cuts" are listed first in the question, I will focus on those in the short run and then tax hikes in the long run. In both cases, the effects of each policy are mirror opposites.

Suppose the government cuts taxes, but does not change spending. This increases disposible income (which is gross income less taxes) so the Income Effect kicks in and people spend (and save) more.

Stock market investors know that disposible incomes result in higher spending and higher saving leads to more people purchasing stocks, so stock prices rise, bringing in a second round of the Income Effect.

This increases GDP through the Consumption component ('C') in a virtuous cycle. Simultaneously, if the government holds spending constant but decreases its revenue (taxes), then government deficits will rise (or surpluses, which are just negative deficits, will shrink) meaning that government has to increase its borrowing (or decrease its lending in the case of a surplus).

This increases the demand for loans (or decreases supply of loans), and the Crowding Out Effect kicks in, decreasing GDP through the Investment ('I') component.

It is impossible to say generally which effect will be stronger (i.e. whether the net effect on GDP will be positive or negative) because it depends on myriad factors such as given interest rates domestically and abroad, consumer preferences, etc.

The above paragraph will take place within the first year and half or so after the tax cut is passed. But suppose the government increases taxes, holding spending constant, what will happen in 5 years? 10 years?

The answer to this question is going to be obviously simplistic, because to isolate the effect of the tax increase, we must assume that no other shocks to the economy occur during this time. Nevertheless, if we increase taxes, the government deficit will decrease. This has many, many effects on the open economy.

First of all, the crowding out effect works in reverse, making investments by firms cheaper, so GDP increases through 'I', which as I mentioned before, is the biggest predictor of future economic growth.

Secondly, high government deficits result in inflation, which if kept in check isn't that big a deal, but it can very quickly spiral out of control and it tends to make people feel poorer (income effect in reverse), so the increased government surplus (or decreased deficit) decreases inflation in the long run and so people don't feel poorer (preventing the income effect from working in reverse).

Most importantly though, government surpluses increase net exports. To explain how this works is outside the scope of this article, but it has to do with Capital Flows and Exchange rates.

A good government surplus increases confidence in the currency and makes it easier for the government to borrow money should it want to in the future, and avoids crises like is currently going on in Greece.

So the answer to the original question: Will economic growth result from tax cuts or tax hikes? is YES, but it depends on whether you mean long term, sustainable growth, or short term stimulus that will pull us out of this economic slump. In the short run, tax hikes are probably the stupidest policy choice possible given the current situation.

Hiking taxes would put us right back in a recession. However, the government deficit is ballooning out of control and when the economy recovers, policy makes should consider raising taxes, much like they did in the Clinton Era.

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