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Monday, February 16, 2009

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.

11 comments:

AnonymousIsAWoman said...

For more information on the economist who came up with Supply Side economics, Arthur Laffer, go to this article in Time, which also debunks the whole idea that tax cuts pay for themselves.

No economist believes that argument anymore. And as the Time article points out, it had a limited one time usefulness due to the certain historic conditions in the 1970s and early 1980s.

John Doe said...

You my dear are an idiot. Tax cuts don't work? How about the pre-back to school holiday our very own Commonwealth gives? Sales go nuts just eliminating our puny sales tax.

Oh, the Pubs "controlled" the Treasury at the time of this bogus report? Just like they "controlled" the CIA and the AGs office, and the State Department, yeah right. Those places are chock full of liberal careerists who are no more conservative or Republican than I am a Martian.

The question that you should be asking: Do I know better how to spend my own money than the Government does, or does the Government know better than I do? If the Government knows better, give them all your money, you ignoramous. If you do, then advocate for them to cut your taxes. What this really is about is that you think the Government knows best how to spend OTHER PEOPLE'S MONEY. You and most liberals are really good at that--taking from others and spending it, rather than taking from yourselves.

AnonymousIsAWoman said...

My my but we are angry today. Hit a nerve did I?

As a matter of fact, during 2006, John Snow was Treasury Secretary. So, yes it was a GOP-controlled cabinet agency under the Bush administration. As for those "liberal careerists" whom you dismiss, they aren't Republicans or Democrats. They are trained economists. Sort of like the trained scientists at other agencies, with whom Republicans also have had so much trouble.

Sorry, but even Arthur Laffer, who invented the Laffer Curve, which Reagan used in his "supply side" economics, no longer completely believes all his theories. They didn't pan out.

As for your example about the tax holiday increasing sales in September, other factors could also be in play. For example, during back to school sales, there's the fact that parents are going to have to buy supplies for their kids anyway. Sales prices and tax holidays may indeed help them to afford more for their children, but even without those incentives, parents are going to have to purchase notebooks, pens, pencils, and clothing. So, that's hardly an example of a major stimulus in action.

John Doe said...

No, you didn't "hit a nerve" other than I call an ignoramous an ignoramous, so if the shoe fits, wear it. Perhaps if you had gone back to the original report created under "Republican controlled Treasury Department" instead of just reading the drivel that was written about it by the liberal website that you cited to you would have seen that the report concluded that GWB's tax cuts HELPED the economy. Read the conclusion on page 17 of 30: "The analysis presented in the paper suggests that permanently extending the President’s tax relief enacted in 2001 and 2003 likely would lead to a long-run increase in the capital stock and an increase in national output in both the short run and the long run." Read it and weep, Ms. Ignoramous. You are citing to the study as proof that "Tax cuts don't work."

Further evidence of your ignorance required? Your article said: "Tax rates are the lowest they’ve ever been for the upper one percent of people."

Hmmm. Whom to believe? Anonymous ignorant woman or the Treasury Department itself? Hmmm. Tough call.

"By 1913, 36 States had ratified the 16th Amendment to the Constitution. In October, Congress passed a new income tax law with rates beginning at 1 percent and rising to 7 percent for taxpayers with income in excess of $500,000. Less than 1 percent of the population paid income tax at the time. Form 1040 was introduced as the standard tax reporting form and, though changed in many ways over the years, remains in use today." If even a dolt can't figure out that the top income tax rate is higher than 7% now, then God help them. So, what else ya got?

http://www.treas.gov/education/fact-sheets/taxes/ustax.shtml

AnonymousIsAWoman said...

You know, I'm going to offer a suggestion. You might want to try being a tad bit more polite. Calling anybody an ignoramus probably weakens your argument by making you look like an uncivil jerk. On the other hand, refraining from ad hominem attacks, growing up, and having a civil debate on the issues might strengthen your influence and make you more effective. Just a suggestion.

If you read everything about the report carefully, you would also see that the Treasury Department issued a caveat that people were drawing the wrong conclusion from some of the things in the report, notably that the tax cuts helped in the long run. In Treasury's additional statement, regarding the misunderstanding and the false way it was being reported, Treasury stated clearly that the tax cut did not help long term growth. And, as they added, they were using a best case scenario, where comensurate cuts in spending were made.

Most of the growth in federal spending actually came from defense spending and spending on intelligence, anti-terrorism activity, and investigating money laundering schemes, related to terrorist activity. Spending on domestic programs was flat.

Given those facts, spending cuts probably were never going to happen and that means the report, even with its negative conclusions about the usefulness of tax cuts, was actually unduly optimistic.

As for your drivel about the top rate being higher now than in 1913, yeah so? Even a dolt can figure out that we have a larger middle class, greater prosperity, and greater equality today than we did back then. And that's with all our problems.

Other than being a non sequitur, I'm not sure the point of dragging that little piece of trivia out.

However, along with learning some civility, you might try a course in logic and making coherent arguments, rather than having temper tantrums.

John Doe said...

Do you ever bother to actually read what you cite to? You claim "no economist believes that claim [that tax cuts don't pay for themselves] and cite to the article which clearly states at least Laffer does:

"And how did things work out? Laffer is CONVINCED that the reduction of the top tax rate from 70% to 28% during the Reagan years PAID FOR ITSELF--in part by encouraging the rich to stop finagling--and the evidence mostly backs him up. "You find these enormous responses in the upper brackets," Laffer says. "These guys fire their lawyers and accountants and actually pay their taxes. Yay! Isn't that what we want them to do?"

Sorry if you think it is somehow uncivil or rude for me to point out the error of your ways.

AnonymousIsAWoman said...

First, it's not uncivil or rude to point out errors or even to disagree. It's very uncivil and extremely rude to call people names, which is what I was objecting to. I'm not an ignoramus and neither are you. But you have been rude.

As for your quoting Laffer, did you actually continue reading the rest of the article, where it also says the following:

"But Reagan's tax cuts for the nonrich were big money losers, and it took the fiscal discipline of Bill Clinton to mop up the resulting red ink. Laffer gushes with praise for Clinton, but he's also a fan of Clinton's successor. "What Clinton did was, he gave Bush the fiscal flexibility to do what was right," Laffer says. In the face of the recession and terrorist attacks of 2001, Bush "needed to stimulate the economy and spend for defense, and Clinton gave him the ability to do that."

In other words, the Bush tax cuts were meant to create big deficits. But Laffer's O.K. with that. "The Laffer Curve should not be the reason you raise or lower taxes," he says. Perhaps not, but it does make for great campaign promises."


I never disputed that when income tax rates were 70 percent, it made sense to cut them. They were too onerous. But cutting back to 25 percent went too far. At that point, you create deficits.

Most economists today believe that. In fact, Stephen Moore and Grover Norquist don't support tax cuts because they believe those cuts pay for themselves. They support tax cuts because they believe in small government and hoped that cutting taxes would force Congress and the President to cut programs. They've said as much.

The question is what do you cut? Keep in mind that domestic spending has been flat and most of the spending has been for military, defense, intelligence, and anti-terrorism activities, including tracking money laundering among terrorist groups.

John Doe said...

Ha ha ha! You are pathetic. Get you away from your little Democrat talking points and you stumble all over yourself. Even the quote that you tried to use from Laffer destroys your theory that tax cuts won't work in this [manufactured by Obama] crisis: Laffer said "Bush needed to stimulate the economy" by giving tax cuts. WHAT?? Anonymous said tax cuts don't stimulate the economy! If you think people weren't scared after 9/11, and that the economy and the stock market didn't tank after 9/11 you are either dumb as a post or blatantly trying to perform history revision. But Bush's tax cuts stimulated the economy. If they could stimulate the economy then, they could stimulate the economy now.

I'd humbly suggest that you got your two Democrat talking points jumbled up. The one where "Republicans always say tax cuts pay for themselves" one is not the same as the "Tax cuts worked in the past but this economic crisis is different and requires HUGE SPENDING BY THE GOVERNMENT TO SAVE US ALL" one.

And it's funny how tax cuts "create huge deficits" in the liberal mind. Oh, it's NEVER the Government spending that creates huge deficits, it's always the tax cuts. Yeah, my lack of income is causing me to go into too much debt, too. If only I could just pass a law and make my clients pay me more money, all my problems would be solved, according to the liberal view of stealing from the rich and giving out Other People's Money to pay for pork projects.

AnonymousIsAWoman said...

No, unlike you, I will print a full quote, not gerry pick what I want from it to force it to say something it doesn't. Laffer gushed over Bill Clinton. He merely said that Clinton's fiscal discipline gave Bush some wriggle room for tax cuts to stimulate the economy. In the tepid downturn of 2001, caused by the bursting of the dot.com bubble and the aftermath of the terrorist attack, tax cuts were an appropriate response. So was lowering the interest rate, which the Fed did numerous times.

We are in a far, far worse situation now. We cannot lower the interest rates anymore because they are already near zero. We've given out massive tax cuts. In other words, we've shot our wad, when it comes to the usual and preferred methods of dealing with a recession.

I may have overstated the case for the stimulus bill and Keynsian economics. Even John Maynard Keynes did not believe the government should rush to intervene in every minor blip in the economy. The remedies he proposed were for true emergencies. Normally, the free markets work very well doing what they were intended to do and are preferable.

Occasionally, there is a situation where the markets collapse and the economy is overwhelmed. That's when the government has to step in to prop it up on life support and get it jump started. That's supposed to be a rare and emergency method. And it carries its own dangers so it shouldn't be be done lightly.

Now, you are also banned because you are an insulting and rude troll. I have many conservative colleagues with whom I will argue endlessly and I respect them.

But your disrespectful tone, insulting language are not welcome here. I've read your blog, btw, and anybody who suggests even as a joke that killing liberals is a solution to global warming and compares them to cows is not a great wit but a blithering idiot. I'd like to think you are 14 or 15 and that your poor mother is really trying hard to teach you good manners. I'd hate to think you are an actual adult.

In any case, take it elsewhere. You are not welcome here. And you have a notable distinction. I've never told that to anybody or banned anybody in the four years I've run this blog.

But it's my joint and trolls just won't be tolerated.

msk08 said...

This is a good post (notwithstanding the trolling you had to endure above). Although the stimulus plan is a lot less progressive in nature than I would have liked to see in shifting the country away from its oil dependency and creating a new sustainable infrastructure based around renewable energy, the spending projects of the federal government will put a down payment on updating our infrastructure that will keep people employed in the long term. Plus, the aid to states and localities will prevent massive layoffs that affect everything from mass transit to classrooms. Tax cuts are an individualized, go-it-alone approach that may be appropriate in a time of prosperity, but with wars, an economic crisis, an oil addiction, a decaying infrasture, and failing public schools, Obama is calling for collective action that requires sacrifices from each citizen in order to revitalize our culture.

As an aside, Bush's first Treasury Secretary, Paul O'Neill, observed that tax incentives for businesses don't necessarily work, since those who aren't doing the right thing will take the money and find some way to get out of their obligation and those who are doing the right thing will take the money and not do any more than they already are doing. I imagine it's a bit of the same scenario with tax cuts in a recession.

I like your website. I have added you to my blogroll.

AnonymousIsAWoman said...

Thank you msk08.

I have to add that Paul O'Neill was, unfortunately, underestimated and under appreciated by many including the mainstream media.

He was right about the tax cuts as not being as much an incentive as conservatives hope for. O'Neill also confirmed that the Bush administration was obssessed with getting into a war with Iraq and capturing Saddam Hussein from the very beginning of the administration and before 9/11 ever happened.

He recounted all this in his book, The Price of Loyalty.