Why Tax Cuts Don't Work

There has been a lot of confusing arguments and counter arguments, flying both ways, about the economic stimulus package. Republicans oppose it because they think it’s laden with pork, contains too much government spending, and doesn’t have enough tax cuts, which they think is the real key to stimulating the economy. Democrats have dismissed these criticisms, claiming that tax cut don’t work and pointing out that all the Republicans are doing is proposing more of the same failed policies that we’ve had for the past eight years under Bush and a GOP controlled Congress.

While the accusations are flying back and forth, you would have to excuse the public for becoming more and more confused. They want something done. But after listening to both sides, they’re also scared of what will be done. On the one hand, it makes sense to them that the Republican insistence on more tax cuts may not be the most effective way to jump-start the economy. After all, isn’t that what we’ve been doing for eight years already, just as the Democrats claim? But the Republican counter arguments about the growth of big government and higher deficits scares people who have been told time and again that large government, soaring deficits, and too much government spending are harmful. With all the counter claims, most people, when asked, are simply frozen. They don’t know.

It might be helpful to explain in clear terms why tax cuts don’t work. So far, all I’ve seen is Democrats dismissing it with a wave of their hand, as if the reasons were so self evident that anybody but a dolt would get it.

Well, the American public is not composed of dolts, just people who have been fed a bunch of misinformation, from conservative politicians and corporate owned mainstream media, for so long they no longer know what to believe. It’s time to illustrate exactly why tax cuts won’t work. But first, let me assure you that no less a federal agency than the Department of Treasury admitted as much back in July of 2006, when it released a study called “A Dynamic Analysis of Permanent Extension of the President’s Tax Relief.”

According to this report, in Center on Budget and Policy Priorities:

This study refutes many of the exaggerated claims about the tax cuts that have been made by the President and other senior Administration officials, the Wall Street Journal editorial page, and various other tax-cut advocates. Contrary to the claim that the tax cuts will have huge impacts on the economy, the Treasury study finds that even under favorable assumptions, making the tax cuts permanent would have a barely perceptible impact on the economy. Under more realistic assumptions, the Treasury study finds that the tax cuts could even hurt the economy.

In addition, the study casts doubt on claims that the tax cuts are responsible for much of the recent growth in investment and jobs. It finds that making the tax cuts permanent would lead initially to lower levels of investment, and would result over the longer term in lower levels of employment (i.e., in fewer jobs).

The Treasury also study decisively refutes the President’s claim that “The economic growth fueled by tax relief has helped send our tax revenues soaring,” — in essence, that the tax cuts have more than paid for themselves. [1] Instead, under the study’s more favorable scenario, the modest economic impact of the tax cuts would offset just 10 percent of the long-run cost of making the tax cuts permanent according to an analysis of the Treasury study by the non-partisan Congressional

Now, this study was done by the Republican controlled Treasury back in 2006, the middle of President Bush’s second term, only months before the November midterm elections swept the GOP out of power in Congress. The report destroys all the Republican myths about tax cuts as a panacea for the U.S.’s economic problems, and that was at a time when they had not yet reached crisis proportions. But it certainly points out that, given how much worse our economy has sunk, going along with Republican demands for less spending on shovel ready job projects and more tax cuts would have an absolutely ruinous effect on the economy. We would be deeper in the budget hole and with even less economic growth. The most damning line in this study, in fact, is its admission that more tax cuts would lead to lower levels of investment and fewer jobs – exactly the opposite of what we desperately need to climb out of the hole we are in.

Now, here is why, in simple common sense terms, tax cuts don’t work. It’s simply human behavior. Let’s do a thought experiment.

Let’s say I want to buy a new 9” mini computer, which is on sale. I can get a great price for it right now (by the way, I do want to buy a new mini computer). The problem is I’ve been hearing unsettling rumors about cutbacks and layoffs at work. There’s been talk that my company might be outsourcing some of our work to Mumbai (that part is imaginary, thank goodness)

Now, I have a generous uncle – let’s call him Sammy. And Uncle Sammy knows I have my heart set on that cute little mini computer, so he gives me a thousand dollars as a birthday gift. He tells me to go buy whatever I want and even to put the left over money in savings. Well, since it’s close to President’s Day, the sales are even better. It’s a great time to buy because Circuit City is offering a going out of business sale and everybody else is advertising low costs to compete. So, I will have money left over to put in savings. It’s really tempting and I’ve been out there doing some comparison shopping. But when I get back to the office, I find that my boss is studying Hindi, and his assistant confides that she’s booked a trip for him to look at a plant in Mumbai.

Now, do I spend the $300 on the mini computer, or do I sock it all away in savings just in case I end up like my neighbor, looking for a job and needing to dip into savings? After all, I’m in a field that has already experienced a lot of outsourcing and a contracting job market.

You know the answer to that. No matter how much I want that mini computer, I’m going to do the responsible thing and put the money in my savings account until the economy shows more strength and my own job situation is more secure.

If you think my imaginary dilemma over whether to buy the computer or save my money for a rainy day is just a straw dog scenario that isn’t really playing out across the country, here’s basically the same scenario, used as an example, by Daniel Gross in Newsweek.

Let's say you're a tenured professor of economics at Harvard. You have—and have earned—a great deal of stability and security. Your job is guaranteed, at pretty much the same salary, until retirement. Your employer, which has been around for more than 350 years, isn't going anywhere. The university provides nice health care benefits and contributes generously to a retirement plan. All of which means you can make pretty good plans about your short- and long-term financial future. If we reduce payroll taxes—or eliminate them entirely—the professor will have an extra $200 in his paycheck every month. And that might yield predictable results. Feeling slightly more flush, he might be more likely to amble down to the Coop and buy a few books or a V-neck Crimson sweater or to invest in a summer home on Cape Cod. That's what a rational person would do. And that would stimulate the economy nicely
Back in the day, and in many of the past episodes of postwar recession, the typical American worker resembled a Harvard professor—not in brains or wit, to be sure, but in the shape of her economic life. Many—not all, but a lot—enjoyed long, relatively secure job tenures, steady incomes, and generous employer-provided health and retirement benefits. But the economy has changed significantly in recent decades. And the circumstances that might prod our professor to start spending those tax cuts immediately might not apply to everybody else. The typical worker—white-collar, blue-collar, no-collar—doesn't have anything like tenure or a guaranteed job. In fact, she may be working at a company that has just laid off 10 percent of its work force and may soon lay off more. She may be one of the 3.6 million people who has lost a job in the last year. She may work in an industry in which one large, longtime player has just liquidated. She might still have employer-provided health insurance, but the company may have just jacked up the employee contribution. She knows that if she loses her job, she would have to start spending several thousand dollars a year to purchase health insurance. Meanwhile, this worker—say she's in her mid-40s—is providing for her own retirement via a 401(k), whose balance has fallen by 40 percent in the last year. Oh, and her adjustable-rate mortgage is about to readjust to a higher rate.

So, what happens if you cut this worker's payroll taxes (assuming she's on somebody's payroll and isn't a contractor or self-employed)? Well, she might spend the increased cash flow. But given everything that's going on, a fearful but still rational person might not rush out to spend or invest the money. She might be far more likely—and well-advised—to save it, to build up a cash hoard that would allow her to remain solvent should she lose her job, or to prepare for the eventuality that she might have to buy her own health insurance. Or she might start shoveling that extra $100 per week into her 401(k) to make up for some of the huge losses she's suffered.

As Mr. Gross points out, psychology plays a role in our economic behavior. So does rationality. So, tax cuts, which might make sense in some scenarios, don't work here. There was a time and a situation where cutting taxes was the right solution to a particular problem – back in the 1970s and early 80s, when the highest tax rate was 70 percent. There was a scandal back then over how many of the super rich were able to avoid paying all their income taxes by hiring cadres of tax lawyers and accountants to find them loopholes and tax shelters. So, when conservative economists suggested that slashing the top tax rates would result in more rich people firing their armies of tax consultants and simply paying those reduced rates, the economists were right, at least for a few years. That’s what gave Ronald Reagan a brief window of success with his tax cuts. But low and behold, he slashed the tax rates too much and soon had to raise them back up somewhat, though never back to the 70 percent, which was too onerous.

Tax rates are the lowest they’ve ever been for the upper one percent of people. And all the tax cuts did was raise the budget deficit to staggering amounts, which will make recovery even harder. But the super rich do not spend more when their tax rates are cut more. They already can afford to buy whatever they want and need. And they already have their investment plans in place. Tax cuts don’t influence them to spend more money on those things. When they get back tax money, they simply put it in savings because it’s excess money. And that doesn’t stimulate the economy.

Now, because of job insecurity, even the middle class is no longer spending at the rate it used to. The days of cheap credit, liquidity and easy spending are over. Most people have seen their 401(k)s shrink to about half of what they were, so they are not in an investing mood either. People are scared their jobs are on the chopping block and they are paying attention to beefing up their savings accounts. If you give them a tax cut, they will stick it in savings too. Or pay down some of their debt. All good things. But they don’t provide the stimulus we need. Yet they do run up the deficit.

The way to get the economy moving in this situation is to provide jobs and build the infrastructure. That’s what will get people at the lower rungs of the economy spending again. Once you staunch the loss of jobs, more people will resume purchasing goods, and the demand cycle will get the economy growing again.

Supply side economics might have had a limited use many years ago. But for jump-starting an economy, you need to pay attention to the demand side economic tools. And tax cuts aren’t it.