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Supply-side economics: Do lower taxes increase a country's economic health?

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Yes		67%	431 votes	Total: 640 votes
No		33%	209 votes	Total: 640 votes

Yes

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Supply-side economics currently has two popular definitions. A Yes or No answer depends on the particular definition the reader embraces. The great schism in modern supply-side economic theory occurs at the fault line of how taxes in particular affect production and consumption, and who should be taxed less in order to support economic growth. On one side are those who say corporations should be taxed less in order to produce supply, resulting in a "trickle down" effect. On the other are those who say consumers should be taxed less in order to create more demand, resulting in an upward cash flow from consumer to producer.

I borrow money. I buy materials and pay you wages to make a widget. You use that money to buy a widget from me. That's the production-consumpti on cycle in a nutshell.

Nearly every economist, regardless of the school of thought they embrace, acknowledges that the supply side of economic supply and demand theory - production - is basic to a healthy, growing economy. Increased supply through production causes higher income and a better standard of living because goods and services, in order to be created and/or made available, require an initial capital investment in the materials and labor required for their creation. This initial investment is reclaimed when the wages paid and profits earned on the production side of the cycle supplies a large number of people with earned money, allowing those people to become consumers and buy the products made.

Strictly speaking, when supply-side economic theory looks at the influence of taxes on production, it wants to establish a marginal tax rate, that is, the point when a tax rate begins to interfere with production and consumption of produced goods and services. Higher tax rates pull money from the production-consumpti on cycle, leaving less money to circlate in the cycle. So everyone is interested in where and from whom tax money should come from, how much is enough, and at what point does it become too much and so detrimental to the economic cycle.

What has happened to the straightforward, simple recognition of the vital nature of a healthy production-consumpti on cycle is what usually happens with human nature: two separate, complex schools of thought about taxation emerged, based primarily on self interest. Production and consumption, rather than being regarded as equally important components of the cycle, were assigned a value of priority which dictated a greater or lesser tax burden for one side or the other. Some said producers were of first priority, and should be taxed less. Others said consumers should come first on such a scale. The logical and obvious conclusion to such a development would be to declare both viewpoints invalid because of the indivisible, interdependent nature of producers and consumers. But the game was afoot, and no birds sang this song.

Today, production-side supporters of low corporate taxation as represented and enacted for the past 25 years or so beginning in the "Reaganomics" era are seeing their support of "trickle-down" corporate favoritism die an ugly death. It turns out that corporate producers must create true value, producing not only a consumable but a consumer as well, so that the flow of money can return to the production cycle after being earned in production and then spent on products. Corporate production did not follow this model. Tax-favored corporations managed to produce large profits which were not related to the production of durable goods and services and did not require support of the consumer side of the cycle. They rode a wave of inflated real estate values and an unprecedented infusion of capital into the economy from consumers who became cash-rich with unearned, re-financed home equity. This phantom value did not come from the production of anything substantial, and so the vital linkage between production and consumption broke down.

What had gone into the production of all this new value? Nothing. What had been created which could be purchased by the consumer? Nothing. What occurred then was inevitable and unavoidable. The consumer consumed credit agreements and so, flush with great piles of inflated cash, went out to cheerfully pay more for existing goods and services. Oil, gasoline, pharmaceuticals, health care, and a myriad of other economic stables rose in cost. Financial producers, loaning money to consumers on the basis of trumped-up, bogus housing values, produced bundles of phantom value, backed them with bogus, unbacked credit default swap agreements and other reassuring but empty instruments of reassurance, and eventually infected the world economy with a huge gas bubble of valueless "value."

And so we reach the bottom line here. Lower taxes, when applied evenly across the board to the production and consumer sides of the economic cycle, leave more value in the pipeline. But... the essential qualifier for any corporate tax cut must carry a requisite, regulatory oversight and require that when capital is left inside the production-consumer continuum, it must be utilized to create real value through the production of durable goods and services, and it must supply and support the consumer side of the cycle.

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No

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by Algernon Moncrieff

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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