It’s Obvious: Cut Taxes, Generate GDP Growth, Create Jobs, right?

It’s obvious, isn’t it:  Reduce taxes to stimulate the economy and job creation?
(this post not for economic sophisticates)

Of course, as the simplified story goes, when the state or federal government reduces income taxes, individuals pay smaller amounts of such taxes each paycheck when less is withheld to pay them.   With less money taken out of their paychecks, people spend more than they would have otherwise, thereby, creating new demand for goods and services.  This new demand snowballs into greater demand that uses up existing production capacity and producers hire new workers to satisfy this new demand.  Seems obvious, right?

Well, it depends on whose taxes we reduce.  If we reduce taxes on those who spend all of their income each pay period, then, they will spend all of the money made available by a tax cut immediately.  If we reduce taxes on those who save some of their income, then, only some of the new money made available will be spent immediately.  In the case of the wealthiest individuals or individuals with the highest pay, a very large portion, if not all of the new money made available will not be spent immediately.

For example, a family of four with an annual income of $70,000 probably saves very little, unless they have a 401k plan, in which case, they may save 3-5% of their income.  So, they are likely to spend 95-97% of each reduction in the taxes they pay.  A family of 4 with an income of $250,000 is far more likely to save 15-20% of their income.  In this case, they are very likely to spend 80-85% of their tax reduction.  If we ascend into the higher regions of incomes, say above $3,000,000 per year, not only the quantities change radically, but the nature of the story changes.  These individuals save at least half of their incomes and earn most of it from capital gains or dividends, forms of economic rent collection, which are already taxed at lower rates than productive incomes at all but the lowest two rates.

Reducing taxes on these people has no positive effect on economic outcomes for any other groups in the short-term.  There may never be a positive effect on economic outcomes from reducing taxes paid by these people.  A large portion of their income re-enters the economy only after it’s passed to the next generation through their estates.  If structured properly, no taxes will be paid on this estate when it’s distributed to the heirs, or taxes will be paid only by the second generation of heirs.

This simple account of the economic effect of tax reduction is nearly as simple as the obvious account, but it’s more accurate and more helpful in policy design (the ultra-simple version is not helpful, so the helpfulness bar is low).  To increase spending in the short-term simply make more money available for families and individuals to spend by having the government reduce income taxes and take less of their incomes.  To maximize the benefits and minimize the costs of this action, reduce income taxes on the poor and lower-middle-income workers while increasing, or not decreasing, taxes on the wealthiest and highest-earning individuals.  In this way, we can optimize GDP stimulation, job creation and funding government activities?  This account is simple, easy to understand and quite reasonable; why do those who would benefit most from it oppose it?

Okay, the big picture is more complex.  What about real property, sales, excise, room, entertainment, luxury, estate and taxes on capital gains?  Or what should we do with road tolls, room taxes, licensing fees, water treatment facility fees, telephone connection fees, cable fees and all those other fees and taxes we pay every day, year or every 5 years?  Funding state and local government is a critical issue that many voters ignore.  The consequences of ignoring this issue when electing state and local representatives and other officials are dire, especially in the long-term.  Note the differences in the quality of education at all levels among the states and the differences between the quality of education after passing tax limitation measures and before passing such measures (California stands out as an example of the outcomes of such measures).  Mitt Romney brought this part of the account to the forefront of discussion when he commented on the 47% of lay-about Americans who pay “no” taxes by inviting the enlightened among us to point out that every American pays at least some of these taxes.

One factor that contributes to the complexity of tax policy is the complexity of the American tax regime.  If we simplify this extensively, we can eliminate most of the cost of implementing and monitoring it and improve the results of collection efforts.


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Filed under Economics, Policy, Taxes

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