Tax Cuts are the Solution to Everything
August 5, 2008
Left-leaning commentators always like to make fun of the Wall Street Journal op-ed page and other such right-leaning outlets who are often quick to recommend a tax cut in the face of virtually any economic problem. Whatever pops up, the “rich people” are there with their tax cut plans. What a bunch of sleazeballs! President Bush still gets a lot of criticism for cutting taxes “for the rich” in 2003, although this was followed immediately by a fairly nice bull market and economic recovery — and a rise in tax revenues, and a smaller budget deficit, if we ignore Iraq expenses.
Actually, a tax cut usually is about the best thing a government can do, in virtually all situations. Let’s see what I mean.
What are some of the other things governments typically do in a recession?
Mail out “tax rebate” checks. This is not a “tax cut” even though it might be labeled a “tax rebate.” The label is unimportant. Functionally, it is a “government check in the mail” no different than Social Security or welfare payments. The effects are very transient. Also, this tends to cost a lot of money.
Devalue the currency. This can provide some short-term effects which might seem positive, but the end result is further impoverishment. You can’t devalue yourself to prosperity.
“Cut interest rates.” Interest rates would fall naturally, in something like a gold standard system, to reflect the overall lower return on capital during a recession. This impulse to “cut interest rates” via artificial means is typically a masked desire to devalue the currency.
Raise taxes. This is typically to “close the budget deficit.” Some states are considering this right now. The federal government is going to effectively raise taxes, by “phasing out” the Bush tax cuts. This “raise taxes to close the deficit” was a major cause of the Great Depression, and also many other economic blowups throughout history into the 1990s. Usually, government budget deficits aren’t really that big a deal. The tax hikes to “close the deficits” can be a big deal, however. Ironically, the tax hikes often cause so much economic deterioration that tax revenues fall rather than rise, and the deficit gets bigger! This is especially true when the recessionary effect of the tax hikes causes further pressure on the government for welfare-type spending.
Welfare spending. Today’s welfare spending, such as food stamps or unemployment insurance, are usually welcome in an economic downturn. However, they typically do little to resolve whatever caused the economic problem in the first place. Also, the combination of increased spending and depressed tax revenues (due to recession) tends to lead to a bigger deficit, and thus calls for higher taxes.
Public works spending. Military-related spending often ends up in this category as well. The idea is to create jobs via government funding. This is a welfare-type activity, and typically does little to resolve the underlying cause of the economic difficulties. Also, it tends to be very, very expensive, which results in “raise taxes to balance the budget” arguments. The effects are usually transient.
Reduce government spending. Usually governments are rather bloated anyway, and what better excuse to go through a downsizing than a recession? If there is a problem with this, it is that it piles government unemployment on top of private-sector unemployment. It would be much better to slim down the government during the boom (OK, that never happens), when government workers could easily find new employment in the private sector. Maybe if a government reduced spending policy were paired with something positive, like a tax cut.
So, you see, what else are you going to do besides cut taxes? A tax cut, in a recession, has some advantages:
If the recession was caused by a tax hike, at least in part, a tax cut is an excellent solution. Herbert Hoover raised the top income tax rate in the United States from 25% to 63%, plus additional taxes on inheritances and businesses. This definitely made the situation worse. Much worse! A good solution for Roosevelt would have been to go back to 25%. Yes — sometimes it is that obvious. In 1997, Thailand’s government was pushed by the IMF to raise its sales tax to 10% from 6%, to reduce the looming budget deficit. (Thailand’s government had run budget surpluses for years, and had very low debt, but the economic crisis caused by the currency crisis affected revenues. The IMF knuckleheads keep pulling the same Herbert Hoover routine over and over.) This produced no positive results, so the Thai government thought about it a bit, and moved the sales tax back to 6% in 1998. See — it’s not really that hard.
If the economic problems have a weak-currency component, a tax cut would help the currency to rise. Especially in emerging markets, where a lot of financing can be in foreign currencies, economic problems often have currency weakness as a component. A significant tax cut — such as the East European-style flat taxes — would have a meaningful currency-supportive effect, in addition to their positive effects in allowing greater economic expansion.
If the economic problems have little to do with taxes, a tax cut would still be one of the most effective ways of inducing a stronger economy. The present problems in the U.S. don’t really have a tax hike component, although they may in 2009 once there is Democratic leadership in Washington. However, if we look at the list of options above, I would say that a meaningful permanent tax cut is one of the best options a government has to create more economic activity. What would the U.S. be like if we enjoyed a Hong Kong style tax system, with a 15% top income and corporate tax rate, and no taxes on interest income, dividends, capital gains, or inheritances? It would probably be a lot more healthy economically. If something is good for an economy in the long run, like a sensible tax system, then it is probably good in the short run as well. Vladimir Putin passed Russia’s 13% flat tax in 2000, the depths of a decade-long economic catastrophe. The result: POW! Galloping economic growth — the most since before the First World War! — and galloping tax revenues. This was no fluke, since many other moribund FSU countries did much the same thing in 2001-2008, with much the same results.
A tax cut works, not because of “putting money in people’s pockets” or some such nonsense, but because it lowers the barriers to transactions in an economy. An economy is all about cooperation, and if there are high taxes, people are not able to cooperate productively. Russia’s 13% flat tax worked because it removed all the “internal trade barriers” caused by taxes.
A tax cut helps dispel the urge to raise taxes. One of the most destructive things a government can do is to raise taxes in a recession. There might not be enough political will to cut taxes dramatically. However, if there is even an eeny beeny tax cut, too small to make any real difference, that would at least tend to cancel any urge to raise taxes. So, cutting taxes can be a useful political exercise, even if it fails.
A tax cut helps dispel the urge to devalue the currency. Once you’ve done what you can do with welfare-type spending, the next thing a government typically reaches for is currency devaluation. Much better to focus attention on a significant tax cut.
A tax cut helps allow a reduction in government spending. Of course a tax cut alteration isn’t spending itself, although it is often referred to in this way. What I’m getting at is: as an economy benefits from a tax cut, people are better off, and thus there is less pressure on the government to “do something,” which often means welfare-type spending. One way that a tax cut can help lead to better government financies is not only that a healthy economy produces more tax revenues, but it is much easier to reduce other spending when the private sector is going strong. If Japan’s government had been aggressive about cutting taxes in the 1990s, for example, there would have been much less pressure to try to keep idle hands busy via the hyperexpensive public works projects. (Whenever economists talk about increasing government spending in terms of “percentage of GDP,” hold on to your wallet!) To take another example, Margaret Thatcher started her term in Britain in 1979 with a big tax cut, which eventually lowered the top income tax rate from 83% to 40% and the corporate tax from 52% to 35%, eliminated a 15% investment income surcharge, reduced the capital gains tax rate from 75% to 30% and indexed it to inflation. It was only after she got the private economy up and running again that she engaged in rolling back the socialist state, which had evolved largely as a reaction to the ill health of the private sector.
Today’s economic problems in the U.S. are mostly due to the previous credit binge. The natural response to this is government bank recapitalization. The U.S. government is being pressed down this path by events as it is, just as other governments (Japan, Britain, France, Sweden, Mexico, Korea) have been pressed down this path in the past. Government spending — the “tax rebates,” welfare, military spending, homeowner bailouts, etc. — has gone about as far as it is going to go. What comes next? Unfortunately, really bad economic problems usually have, at their root, high or rising taxes and monetary instability. It looks like we have both coming up. Bernanke is obviously a devaluationist at heart, who believes that the Great Depression was caused or worsened by the fact that the world’s major governments — every one of which devalued their currency — did not devalue quickly enough or dramatically enough. The Democratic Party is anxious to rub out whatever tax-cutting legacy was left by Bush, plus pile on some additional taxes. The real crunch may come in a year or two, when the economy may be really coming apart and tax revenues at governments are sagging badly. A typical Democrat response would be: more devaluation, more government spending, and more tax hikes to supposedly pay for the spending.
This was not always the case. Roosevelt made arguments for a tax cut in the 1932 elections — and promptly forgot them afterwards, although his Secretary of State Cordell Hull did make many efforts to reduce tariffs worldwide. John F. Kennedy enacted a big tax cut, on which the later Reagan tax cut was modeled. In 1974-1975, a terrible recession, the Democrats tried to push through a significant tax cut, and were indeed successful although the result was much watered-down (by Republican opposition). Jimmy Carter campaigned in 1976 on vague tax-reform promises (and did nothing afterwards).
The Republican’s 1977 Kemp-Roth bill proposed what was essentially a carbon copy of the Kennedy tax cuts. This was narrowly defeated in the Democrat-controlled Congress, but it was revived in 1978 by Democrat Sam Nunn as the Nunn Amendment, and passed both houses of Democrat-controlled Congress. Bill Clinton promised a “middle class tax cut” in the recession in 1992, and soon forgot all about it. Now we have Obama making some suggestions about lower taxes for lower incomes. I’m all for a $40,000 per adult standard deductible. There are better systems (look at the East European examples), but that would help and it’s something the Democrats might rally around. It would help get their mind off tax hikes at least.
It really irks Democrats when you remind them that John F. Kennedy was a tax cutter. And, it really irks Republicans when you remind them that Kennedy’s tax cut plans were opposed by the Republicans, who were obsessed with “balancing the budget”. A decent book on the Kennedy tax cut was written by Herbert Stein, called The Fiscal Revolution in America. It was published in 1969, and begins with this paragraph:
Herbert Hoover recommended a big tax increase in 1931 when unemployment was extremely high and a large budget deficit was in prospect.
John F. Kennedy recommended a big tax reduction in 1962 when unemployment was again a problem, although a much less serious one, and a large budget deficit was again in prospect.
The contrast between these two Presidential decisions symbolizes the revolution in fiscal policy that occurred in the intervening thirty-one years. . . . Hoover proposed a tax increase both to raise employment and balance the budget. Kennedy proposed a tax cut both to balance the budget and raise employment. [Stein’s emphasis.]
And what happened? The Kennedy tax cut was passed posthumously by Johnson in 1964. An economic boom commenced, and in 1965, the government was on track to run a budget surplus — if it had not been weighed down by Johnson’s Vietnam expenses.
Surprised? Vladmir Putin wouldn’t be.