Tax Cuts

During recessions, the government will occasionally offer a tax cut as an economic stimulus. In rough terms, a tax cut of one trillion dollars over ten years will "give back" an amount equal to about one percent of consumer spending annually over that period.

The first question about tax cuts is, exactly how do they stimulate the economy? This is not a stupid question! Remember, if the government gives us a tax cut they'll still have to make up the budget shortfall somehow, chiefly by selling more bonds to American citizens (who happen to be the same people getting the tax cut) or foreigners (who will raise the money by selling us more of their goods and services, or buying less of ours). In other words, government spending will keep sucking money out of the private sector, only the payment method will be different.

Yet most economists seem to agree that tax cuts really do provide a stimulus. The real reason may be that they provide flexibility: people who want to consume more can use their tax cut for that purpose; people who want to save more can use theirs to buy up the new government bonds. This is the perfect scenario during a recession, when prior over-investment has resulted in bloated inventory levels and poor private investment opportunities.

(A less rosy way to put it: tax cuts are really a sneaky way to increase consumers' credit lines. If you spend your tax cut you are in fact spending borrowed money, lent to you by the people who bought the bonds. You'll pay the lenders back later, with interest, in the form of future taxes.)


Who Should Benefit?

The next interesting question about tax cuts is who should get them. Here is a summary of IRS data for 2001 showing who pays what:

This group... Pays about...
The richest 5%   53% ($470 Billion) of the total income tax revenue
The next   20%   30% ($260 Billion)
The next   25%   13% ($120 Billion)
The bottom 50%     4% ($35 Billion)

(Note: this is for income tax only. See the definition of payroll tax.)

The thing to notice is how much of the revenue comes from the upper brackets. That's the most important fact in the world (!) because it's the key to how both political parties approach fiscal policy. Conservatives argue that the bulk of a tax cut should go to the wealthy since they carry such a disproportionate amount of the burden; besides, they're more likely to invest their tax cut instead of spending it, and investment is where economic growth comes from. Liberals counter that during a recession you need more consumption, not investment; and you can afford to give significant benefits to practically everybody just by jacking up the tax rate on the richest five percent.


Recent Example

The juiciest part of The Price of Loyalty is a 2002 White House meeting where Treasury Secretary Paul O'Neill counsels against further tax cuts, saying

Mr. President, the Business Round Table of the country's leading CEOs says the focus should be on boosting consumption demand. Their warehouses are full. They need a boost in demand to clear away inventories. I'm not sure that a tax cut that benefits mostly wealthy investors, many of whom will just push these gains into savings, will do much for demand.
Nobody bothers to respond, since O'Neill is about to get fired anyway. But an intelligent conservative response would be that you can't give money only to people who really need it and want to spend it; you also have to give some to people who will use it to buy up those extra bonds - and that means people who are doing relatively well. The other way to sell more bonds is to raise interest rates, which is not a good option during a recession.

Article Contents
GDP Diagram
Government Spending
Tax Cuts
Economic Indicators
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