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When a tax cut isn't a tax cut

Posted By Russ Roberts On January 6, 2009 @ 12:58 pm In Stimulus | Comments Disabled

If the government cuts rates or just gives rebates but at the same time increases the size of government, taxes are not lower. They’re larger. Government is taking a bigger share of the economic pie leaving less for the private sector to spend. The future burden of taxes is higher. As Milton Friedman used to argue, don’t focus on how government is financed, whether it’s out of current taxes or future taxes. Focus on the spending. If government grows as a percentage of the economy, then the burden on the private sector is bigger.

Taxes have risen since George Bush became president. Federal spending as a proportion of GDP has increased since 2001. Bush didn’t cut taxes. He rearranged the burden of taxes. But he didn’t reduce taxes. He increased them because the bill for the higher spending will still have to be paid.

One way to see this (and to see why tax cuts unaccompanied by spending cuts aren’t stimulative) is to think about the government eliminating ALL taxes in 2009. No payroll tax. No income taxes on individuals or businesses. So everyone "has more money to spend." I put that in quotes because it’s not true. If government keeps the level of spending constant while collecting no taxes, then my taxes in the future are going to be double (actually more than double to cover the interest) than they otherwise would be. I’m also assuming the government will be able to sell trillions of dollars of bonds to cover the spending. In that world, would you run out to buy a car or a new plasma TV with your increased income?

Maybe. If you were sufficiently myopic or if you paid no taxes and got a check from the government, you might. But many people are going to worry about the future taxes they’re going to have to pay. They’re going to spend less. Moreover, if the government keeps using goods and services what is going to be available for taxpayers to buy with all the money burning a hole in their pocket? After all, government hasn’t gotten smaller. It’s still using concrete to build those bridges. It’s still using workers to build those bridges. You have to argue that there are all these idle resources wasting away that will spring into life once people have all the extra money. It’s possible as long as resources are sufficiently fluid and if enough people ignore the implications for the future of a $3 trillion deficit. But what is the evidence for this claim?

When unemployment is 6.7%, why will a $750 billion increase in government make the economy bigger? The main effect is to rearrange what we have. We’re going to have more bridges. We already have plenty [1] (HT: MR [2]).

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[1] already have plenty: http://www.nytimes.com/2008/11/19/business/economy/19leonhardt.html

[2] MR: http://www.marginalrevolution.com/marginalrevolution/2008/11/infrastructure.html

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