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by Algy Moncrieff

Created on: May 25, 2007   Last Updated: June 04, 2009

The effects of a tax on an economy are wide ranging and will have different effects depending on what sort of tax they are and what position in the economic cycle the economy is in. Therefore, to say that lower taxes will increase a country's economic health is not correct, because lower taxes will only increase a country's economic health under certain conditions.

First, allow me to introduce a few terms. The Mundell-Fleming model of the open economy is a powerful model for assessing the effects of certain factors that influence an economy. This makes a few assumptions:

1. Perfect capital mobility - the economy can borrow or lend as much as it wants on world markets

2. Small economy - the economy is small, which in this case means that its borrowing and lending does not affect the world interest rate, r*

3. Open economy - the economy can trade with the rest of the world, if this is to its advantage.

The Mundell-Fleming model, based on a large amount of research (Mundell won the Nobel Prize in 1999), gives the equation for national income as:

Y = C(Y - T) + I(r*) + G + NX(e)

This says that national income (Y) is equal to consumption (C) which is a function of disposable income (Y - T(tax)), plus investment (I) as a function of the world interest rate (r*), plus government spending (G), plus net exports (NX = X(exports) - M(imports)). Thus, if any one of these factors changes, national income (aka growth), will be affected. Or rather, it will be affected in the short run - in the long run we have only got limited natural resources and technology so Y must be fixed. Therefore an increase in C will mean that prices will have to rise to accommodate the increased demand, and the result will simply be inflation.

The traditional view of a tax cut is that it will stimulate consumer spending, reducing saving, which implies an increase in interest rates and a reduction in investment. Another view though was suggested by David Ricardo - that of Ricardian Equivalence. This is the idea that consumers are forward looking and therefore will base their spending decisions not only on their current income but also on their expectations of future income. A tax cut will therefore be unlikely under this view to increase consumer spending, because consumers will realise that the only way the government will be able to finance the tax cut is by increasing taxes in the future, unless government spending decreases, but then it will be the fall in G not T that stimulates consumer spending. Thus a tax cut may have no effect at all on a country's economic health.

This may or may not be the case. Firstly, many consumers may be short sighted and not realise they will have to pay the money back at some point, therefore they will adjust their consumption accordingly and the classical view will be the result. Secondly, the consumers may have a strong preference for current consumption - the tax cut is effectively a loan, so such consumers will view this as a 'free' (or at least unavoidable) loan, and spend more accordingly. Finally, consumers may simply expect the burden to fall on future generations and not care, although economist Robert Barro argued that this was not the case[1].

Another important concept with regards to taxation is the Laffer curve. Famously sketched by Arthur Laffer on the back of a napkin in a restaurant, the Laffer curve shows that as taxes increase towards 100% of income, initially the tax revenue the government collects will increase as they take more of people's incomes. However, very high taxes will create a disincentive to work, and so as taxes approach 100% the revenue received by the government will rapidly decline as the best workers flee overseas, people dodge taxes, and others simply refuse to work. In this sense taxes should be moderate if the government wants maximum revenue, and depending on your position on the curve a tax cut may increase or decrease tax revenue.

Furthermore, the effect of taxes is not just on the balance sheets of the government and the population. Taxes have a redistributive effect too. Many people would argue that taxing the rich as much as possible and the poor as little as possible, and using the money to provide services that mainly those on low incomes benefit from (unemployment benefit for instance) will help reduce economic inequality. In this sense lower taxes may or may not improve a country's economic health, depending on which section of the economy you are dealing with.

Finally, a tax may be used to correct a market failure, namely the presence of externalities, or missing markets. This is where, for instance, a polluting factory does damage to society that comes to a greater cost than its costs of producing whatever output of goods it may make. A tax can be used to increase the costs of the firm, making it reduce its output to the socially optimum level - the polluter pays. The tax should be equal to the damage that each unit of the good produced causes over and above what the firm is already paying for - this is known as the marginal damage. The optimal level of the tax therefore will eradicate all marginal damage and nothing more - this is known as a Pigouvian tax after Arthur Pigou, the economist who invented it. In this case therefore there is a good argument for increasing taxes rather than cutting them.

-References-

1. Robert J. Barro; 'Are government bonds net wealth?'; Journal of Political Economy; Vol. 82 No. 6; 1974

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