The Economic Case for Tax Cuts

by Don Boudreaux on May 26, 2009

in Myths and Fallacies, Taxes

Here’s a letter that I sent on Sunday to the New York Times:

You write as though the only reason to cut taxes is to promote more consumer demand (“The Sorry State of the States,” May 24).  You’re mistaken.

By far, the chief economic reason for cutting taxes is to increase the return to productive activity – to increase the return to investment, to risk-taking, to creativity, to work.  The economic justification for lower taxes rests squarely on the understanding that cutting marginal tax rates makes profitable many productive efforts, including hiring more workers, that are unprofitable at higher tax rates.

Why does this straightforward point seem so taxing to your editorial-writers’ comprehension?

Sincerely,
Donald J. Boudreaux

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Daniel Kuehn May 26, 2009 at 10:24 am

These seem to be two sides of the same coin – aren't they?

Randy May 26, 2009 at 11:02 am

Don,

"Why does this straightforward point seem so taxing to your editorial-writers' comprehension?"

Because these folks honestly believe that Political activity is Productive activity. If only that were true…

Speedmaster May 26, 2009 at 11:15 am

>> "Because these folks honestly believe that Political activity is Productive activity."

Randy, sadly, it is for some. ;-)

Daniel Kuehn May 26, 2009 at 11:22 am

Randy -
What does their equation of "political activity" and "productive activity" (if they even do that) have to do with their interpretation of the impact of a tax cut?

I'm personally confused by Don's concerns. The whole reason why tax cuts increase the returns to work is that they provide an income effect that enables stronger aggregate demand, given preferences that are the same as before. It's two sides of the same coin. Tax cuts increase returns to work because workers enjoy the returns inherent by tax cuts.

I think perhaps the more frustrating issue for our host is that their talk of consumer demand smacks of the aggregates that frustrate him so much.

But analytically I see nothing wrong with the original article – and I see no relevance to your comments, Randy.

Veritas May 26, 2009 at 11:34 am

The only aggregate that has any real meaning is the aggregate of one.

Try to apply it beyond the individual and you are just fooling yourself with clever math.

Daniel Kuehn May 26, 2009 at 11:39 am

Veritas -
I think it's a little naive, but this IS really the major bone of contention here as I see it – the heart of the issue – and not that the newspaper is somehow ignorant of why tax cuts are good things.

Randy May 26, 2009 at 11:52 am

Daniel,

If political activity was truly productive, then there would be no difference between tax cuts and political spending in terms of income effects. A dollar spent on desired government sector services would be no different than a dollar spent on desired private sector services. But because political spending is not productive there is a difference. That is, political spending is only redistribution (from the productive class to the political class) and therefore has no net income effect.

Methinks May 26, 2009 at 11:56 am

"The whole reason why tax cuts increase the returns to work"

No. That's not the whole reason. Lower taxes increase return on investment. Investment creates jobs. A reduction in employment taxes makes hiring even cheaper.

Allowing private industry to allocate resources means less waste than government creates when creating make-work projects that you favour. You probably don't get Don's post because you don't think wasting resources is a big deal – as per your previous posts.

Daniel Kuehn May 26, 2009 at 12:00 pm

Randy -
First, I think you're off in that you're implicitly assuming constant MPC.

But I do see what you're getting at now – not Don's point per se, but the approach of the article that "you have to balance the budget somehow so what's the better way to do it – by spending cuts or tax cuts". That is a somewhat crass way to look at the problem, I agree.

I think it's important to keep in mind, though, that appropriations by the government aren't all "redistribution" – government spending does a lot of different things. I think the "which is the best way to balance the budget" question (if balancing the budget is even a good thing at that point in time) is going to be very context specific. And certainly in a huge number of contexts, the answer is "don't raise taxes – cut spending".

Daniel Kuehn May 26, 2009 at 12:08 pm

Methinks -

RE: "No. That's not the whole reason. Lower taxes increase return on investment. Investment creates jobs. A reduction in employment taxes makes hiring even cheaper."

Do you just comment on the assumption that I'm stupid? Of course cutting taxes helps investment too. Don also mentioned "creativity" and "risk taking" as well. Does your omission of those two in your explanation of where I went astray on the benefits of tax cuts imply that you don't understand the benefits of tax cuts for risk taking and creativity? Give me a break Methinks. I just mentioned "work" as one example of the four things that Don listed because there didn't seem to be a point to repeating four different things. It's obvious that the explanation is analogous for any of them.

RE: "You probably don't get Don's post because you don't think wasting resources is a big deal – as per your previous posts."

I'm AGREEING with Don's post. Are you deliberately trying to stir something up, Methinks? I'm just saying that "tax cuts increase consumer demand" is the flip side of "tax cuts increase returns to work" (analogously, "tax cuts increase investment demand" is the flips side of "tax cuts increase returns to investment"). In that sense, I don't understand why Don has a big problem with this article (unless it's a concern about "consumer demand" being associated with aggregation as method).

Tell me, Methinks – is it even possible to let me agree with you, or do you just like disagreeing for the sake of disagreeing??????

Kevin May 26, 2009 at 12:28 pm

These seem to be two sides of the same coin – aren't they?

I don't think so. I think Don's use of "by far" is appropriate. Marginal consumption may be the date stamped on the coin, but it's definitely not a whole side. Don's questioning NYT's eagerness to focus on the date stamp when the whole coin is much more important.

Pingry May 26, 2009 at 1:11 pm

Don,

You write that "the economic justification for lower taxes rests squarely on the understanding that cutting marginal tax rates makes profitable many productive efforts, including hiring more workers."

I agree that lower taxes can increase profitability. Also, cutting taxes induces an additional quantity supplied of labor, despite that being rather insensitive.

While I have criticisms of the supply-siders claim that tax cuts pay for themselves, I believe that a far more important justification for lowering taxes is simply one of allowing people to rightfully keep what they earn instead of forcefully forking it over to kleptocrats in government.

But your claim that one of the productive efforts of lower tax rates leads to more hiring, is only a short-run phenomenon.

After all, most economists accept the natural rate hypothesis (except those that promote the hysteresis view), and in the long-run, unemployment is a function of the number of people in the labor force, not tax policy, no matter what the marginal rate may be, or other government stupidity.

–Pingry

Methinks May 26, 2009 at 1:27 pm

Do you just comment on the assumption that I'm stupid?

Yes

Are you deliberately trying to stir something up, Methinks?

Obviously

is it even possible to let me agree with you, or do you just like disagreeing for the sake of disagreeing??????

It must suck for you to be so misunderstood and so victimized.

Daniel Kuehn May 26, 2009 at 1:38 pm

Methinks -
RE: "It must suck for you to be so misunderstood and so victimized."

Oh yes, it's a wretched existence :)

I don't feel victimized at all – perhaps a little misunderstood. I'm just constantly baffled that I can come on here and agree with two posts of Don's with some minor differences, and get so much ink dedicated to an attempt to convince me that I don't actually agree with him!

… yes I know there's no actual ink involved ;-)

Veritas May 26, 2009 at 1:57 pm

Daniel,

Don is getting to the heart of the media's problem with the seen vs. the unseen.

It is easy to report that stores are selling out of Tickle-Me-Elmos at Christmas time.

Consumption is conspicuous. But consumption is not the total economic activity.

The news media does not grasp this concept, because their news-reporting incentives are not aligned towards this goal.

They need quick, sound byte stories, with busy action shots of beeping cash registers.

The man 5 towns away who cannot buy a Tickle-Me-Elmo because of the effects of taxation never makes it on the evening news.

Daniel Kuehn May 26, 2009 at 2:07 pm

Veritas -

I guess what I'm saying is that I agree with this:

"Consumption is conspicuous. But consumption is not the total economic activity",

but don't see how that necessarily implies this:

"The news media does not grasp this concept, because their news-reporting incentives are not aligned towards this goal."

It's one article! I don't think you can make any broad claims based on a line in one article. The emphasis on the consumption side of the coin seems to me to be there because we're in the middle of a recession that most people agree is caused by the collapse of consumer demand which was in turn caused by the collapse in asset values.

Methinks May 26, 2009 at 2:08 pm

Daniel,

It'll be okay.

Veritas May 26, 2009 at 2:20 pm

Daniel

I thought you were a public policy student!

Surely you have studied the news media!

I remember my own political science classes on Politics and the Media making it clear how the business of reporting is reflected in the news that reaches us.

Reporters aren't malicious, they are just responding to their incentives.

I don't need to provide you with 100 news articles to illustrate that.

It has less to do with their own politico-economic agendas, and more with their need for neatly packaged, visual news stories.

Consumption economics simply provides a better narrative.

Maybe they don't teach that at your school?

Thoughtfully Yours May 26, 2009 at 2:23 pm

"most people agree is caused by the collapse of consumer demand"
^^^
This is garbage economics.

The recession is the cure!

We have too much debt, too little savings and we spend beyond our productive capacity.

Consumption is down, because it was always too high.

We are coming down off of our credit fueled "high".

S Andrews May 26, 2009 at 2:29 pm

It's one article! I don't think you can make any broad claims based on a line in one article.

Don Boudreaux has been sending letters to NY Times for many years. Yes, it is not just one article, but many; it is not just one line, but many.

Daniel Kuehn May 26, 2009 at 2:35 pm

Thoughtfully Yours -
You misunderstand me. I agree that the recession is the cure and that consumption was too high, and that it was fueled by debt which is how all this started.

The point is, unemployment is up right now because consumption is down. That doesn't mean that debt-fueled consumption was a good thing! It's just saying that if people don't buy what they used to buy, people won't produce what they used to produce, and if that happens long enough, people won't work where they used to work!

This is Schumpeter's creative destruction – and it's not inherently a bad thing.

But if you're looking for the immediate cause of the recession, it is the collapse in consumption. What exactly is "garbage economics" about that?

Daniel Kuehn May 26, 2009 at 2:39 pm

Veritas -
I've only taken one political science class in my life, but yes – I'd agree that media responds to it's incentives and that those incentives are usually pretty clearly revealed by what we see in the media. That just seems like common sense.

I don't see how that shows that the fact that this news source chose to mention the impact of tax cuts on consumption implies that media is ignorant of all the other effects of tax cuts that it chose not to mention – PARTICULARLY when those other effects are very very closely related to the impact on consumption. Must the media catalogue every possible impact of tax cuts every time tax cuts are mentioned?

Veritas May 26, 2009 at 2:52 pm

You call it cataloguing.

I call it responsible journalism acting as the lubricant of our democracy.

Why can't the media elevate the discussion, instead of debasing it?

Ever see Idiocracy?

Thoughtfully Yours May 26, 2009 at 2:52 pm

So you agree that the recession is a good thing?

Daniel Kuehn May 26, 2009 at 2:59 pm

Thoughtfully Yours -
I don't think a "recession" is inherently good or bad. I think recessions are corrective in many ways, but they also hurt in the near term. So I wouldn't come out and say it's "good". I like Schumpeter's take – that it's "creative". But I also like Keynes's take – that in addition to being creative and corrective, certain recessions can feed on themselves beyond what is necessary for market correction.

Does that mean that recessions are "good"? I don't know if I'd put it in those terms, exactly, but I would say that I agree with every statement you made except for "this is garbage economics".

Pingry May 26, 2009 at 3:42 pm

What is all of this talk about recessions being "good" ????

Wrong, wrong, wrong!

Many people have the mistaken belief that the "role" of a recession is to "flush out the fat" by "culling inefficient and uncompetitive firms" in order to "mop up the excess" and "liquidate the malinvestment" so that we can "pave the way" for the next expansion.

This fallacy stems from the convoluted belief that the invisible hand only works to drive weak companies into bankruptcy to free up scarce resources when the economy suffers some downturn from insufficient aggregate demand.

Bullshit!

If recessions were indeed necessary to "flush out the fat" and "liquidate the malinvestment" as many otherwise smart people believe, then one would expect not only many bankruptcies and firm closures during recessions, but very few during booms. But the invisible hand works its magic through a highly dynamic process of resource churning irrespective of the state of the business cycle when unhindered by the iron fist of the state.

A recession to clean out the fat is about as necessary as a heart attack to clean out the arteries.

Indeed, the best situation is one in which we strive for perfect price stability at the macro level and perfect price flexibility at the micro level, both within the context of a free and open economic system which operates as near as possible to the NAIRU so that the invisible hand can work its magic without anyone worrying about the devastating effects of cyclical unemployment.

–Pingry

Thoughtfully Yours May 26, 2009 at 3:43 pm

I didn't mean garbage in a pejorative sense.

Garbage is created during destruction.

You were driving towards the creative destruction argument.

How would "garbage economics" not describe your argument?

Recessions only feed on themselves when there is a strong armed government forcing the feeding.

Thoughtfully Yours May 26, 2009 at 4:04 pm

A recession is good, because in this case, the recession is nothing more complex than the credit card bill showing up in the mail.

We pumped up the money supply, eased lending practices, borrowed a fortune, producers flooded the markets with durable goods, accounting practices distorted asset pricing…

We thought we were richer than we are.

Our production (our real wealth) did not match our paper wealth.

This recession is simply an accounting maneuver. We are trying to stop cooking the books.

SaulOhio May 26, 2009 at 4:23 pm

The most important reason to cut taxes is because the money belongs to the people who earned it in the first place. All the economic justifications are consequences of this fact.

muirgeo May 26, 2009 at 4:40 pm

Why does this straightforward point seem so taxing to your editorial-writers' comprehension?

Sincerely,
Donald J. Boudreaux

Maybe because we look at real world results. If anything productivity has been higher in times of higher marginal tax rates.

Bill Clinton increased tax rates and unemployment fell to 4%. Busg cut taxes and now unemployment is on its way up to 10%.

Straightforward??? i don't think so.

Maybe when there are very high marginal tax rates and no off shore tax shelters for CEO's to hide there massive holding from doing anything productive they instead re-invest that money into growing the company and thus jobs, wages and the economy. THAT makes ense to me and fits with the real world facts.

"Reality has a well-known liberal bias."

Stephen Colbert

muirgeo May 26, 2009 at 4:43 pm

But because political spending is not productive there is a difference. That is, political spending is only redistribution (from the productive class to the political class) and therefore has no net income effect.

Posted by: Randy

Yeah because all those trucks delivering goods and services don't use public roads.

muirgeo May 26, 2009 at 4:47 pm

Allowing private industry to allocate resources means less waste than government creates when creating make-work projects that you favour.

Posted by: Methinks

Yeah because CDO's and OTC derivatives did SOOOOOO well. Jesus H….

You all have no clothes so quit pre-tending your all dressed up and ready for the Prom.

S Andrews May 26, 2009 at 4:54 pm

Maybe because we look at real world results.

When did muirgeo become editorial writer @ NY times. Any wonder why NY Times is going out of business?

MnM May 26, 2009 at 4:55 pm

Yeah because CDO's and OTC derivatives did SOOOOOO well. Jesus H….

She didn't say no waste, she said less.

This is incredible. A "gotcha" post that has precisely nothing to do with what she said…

Veritas May 26, 2009 at 4:58 pm

Muirgeo,

My company made billions of dollars on CDOs and OTCs.

But that would contradict your narrative.

I also find your treatment of Clintonian taxation to be quite fallacious…post-hoc ergo propter hoc…

Private roads work even better! Look at states that sell their toll roads to outside firms!

Your posts just hit an unholy trinity of bad ideas!

Impressive.

S Andrews May 26, 2009 at 4:58 pm

Yeah because CDO's and OTC derivatives did SOOOOOO well. Jesus H….

That's why you are a communist.

John Dewey May 26, 2009 at 5:17 pm

Assume that the reason for cutting taxes is to promote more consumer demand. Wouldn't the government be able to also promote demand by giving dollars to every citizen, taxpayer and non-taxpayer alike?

The problem with that idea is that there is a big difference between:

a. increasing after-tax returns to the productive; and

b. transferring some portion of wealth to the non-productive.

It should be obvious that the goal of "promoting consumer demand" can be twisted to justify massive, inefficient wealth transfers. The goal of "increasing the return to productive activity" cannot be so twisted. These are not two sides of the same coin.

John Dewey May 26, 2009 at 5:25 pm

It disturbs me greatly when liberals try to rewrite history.

Tax Cuts, Not the Clinton Tax Hike, Produced the 1990s Boom:

"The evidence is persuasive that the tax increase probably slowed the economy compared to the growth it would have achieved and that the subsequent tax cuts of 1997, not the tax increases, were the source of the acceleration in real growth in the latter half of the decade."

Randy May 26, 2009 at 5:28 pm

M,

"Yeah because all those trucks delivering goods and services don't use public roads.

Are you not aware of the severe negative ecological consequences of over building the public roads? Do you think we'd have as many if the transportation industry had had to build their own damn roads?

John Dewey May 26, 2009 at 5:39 pm

randy: "Do you think we'd have as many if the transportation industry had had to build their own damn roads?"

Not sure if you are being serious, Randy.

The highways are funded by taxes on gasoline and diesel. So highway users are paying for their roads even if not actually building them.

If highway users actually built the roads they use, we'd have the same major arteries we have. Those major arteries would be better maintained. After all, money wouldn't be siphoned off to fund mass transit.

Of course, the fine country highways that connect Boondocks to Hayseed Corner would not have been built. They only exist because of the political pull of lifetime legislators.

S Andrews May 26, 2009 at 6:14 pm

The highways are funded by taxes on gasoline and diesel. So highway users are paying for their roads even if not actually building them.

True, but do you have any idea how much of your gasoline price is tax? How much you are paying for the road on a daily, weekly or monthly basis?

People might make different decisions about how much to use the road, if they knew exactly how much it is costing them.

John Dewey May 26, 2009 at 6:44 pm

S Andrews: "People might make different decisions about how much to use the road, if they knew exactly how much it is costing them."

Not sure I understand. Why would their demand for vehicle fuel be any different if consumers knew what portion was taxes and what was fuel cost?

Methinks May 26, 2009 at 6:54 pm

She didn't say no waste, she said less.

That's true. But CDOs and OTC derivatives (not that Morongeo knows what those are) are not "waste" allocated by the free market. Those products also aren't an allocation of resources as the allocation of resources is represented by the underlying, not by the insurance or the securitization of loans.

K Ackermann May 26, 2009 at 7:00 pm

John Dewey,

J.D. Foster (or the Heritage Foundation) is not exactly an unbiased source.

The bias shows in the quote you supplied. He claims that the growth should have been better than what was experienced after Clinton's tax hike, but based on that premise, then growth should have been spectacular under all the Bush tax cuts.

Year Clinton Bush
————————-
1993 2.67
1994 4.07
1995 2.17
1996 4.46
1997 4.49
1998 4.17
1999 3.86
2000 4.24
2001 0.75
2002 1.59
2003 2.70
2004 4.21
2005 3.52
2006 3.50
2007 3.20

Source: http://www.ers.usda.gov/Data/Macroeconomics/Data/HistoricalRealGDPValues.xls

Now, when you take into account that Clinton handed Bush a surplus, and then Bush ran us back into massive deficits, then those tax cuts look pretty costly.

I see no evidence that tax cuts do anything. Show me the proof.

K Ackermann May 26, 2009 at 7:01 pm

Sorry. The table lost formatting.

John Dewey May 26, 2009 at 7:20 pm

K Ackerman: "J.D. Foster (or the Heritage Foundation) is not exactly an unbiased source."

According to you.

As far as I am concerned, the arguments J. D. Foster provided are sound.

K Ackerman: "I see no evidence that tax cuts do anything. Show me the proof."

The proof was in the link I provided. I didn't expect it would change your opinion. I only responded to your comment in order to influence others who might read it.

K Ackerman: "when you take into account that Clinton handed Bush a surplus"

Clinton and Gingrich achieved a surplus after Clinton agreed that "the era of big government is over" and reduced the growth in spending.

K Ackerman: "Bush ran us back into massive deficits, then those tax cuts look pretty costly."

The Bush tax cuts implemented at the end of 2003 did exactly what was promised: sharply increased tax revenues after the economy boomed. The deficits were not caused by Bush tax cuts but by runaway government spending by the Republiucans.

muirgeo May 26, 2009 at 7:28 pm

It disturbs me greatly when liberals try to rewrite history.

Tax Cuts, Not the Clinton Tax Hike, Produced the 1990s Boom:

Posted by: John Dewey

OK so you think you've explained away the Clinton paradox and a supposed re-write of history on my part… how about the present. 8 years after massive tax cuts we sit in a dumpster of a destroyed economy.

Sighhhh…Explain away.

S Andrews May 26, 2009 at 7:32 pm

Muirgeo,

Did you apologize for claiming that you work for the NYT editorial board? Did you apologize for your communist ideology, while pretending to be a Keynesian, all at the same time having never read a word of what Keynes has read?

muirgeo May 26, 2009 at 7:33 pm

Those products also aren't an allocation of resources as the allocation of resources is represented by the underlying, not by the insurance or the securitization of loans.

Posted by: Methinks

Oh OK and The Market Gods did sooooo well with "the underlying". Yeah I know it's all Barney Frank's fault.

S Andrews May 26, 2009 at 7:41 pm

Why would their demand for vehicle fuel be any different if consumers knew what portion was taxes and what was fuel cost?

You understood me wrong. I didn't say that the consumers would choose to use a different quantity fuel if they knew how much road taxes are being attached to the fuel cost. I said, if they were paying for using the roads directly in usage fees, the choices that the consumers would make will be radically different.

Or that's what I meant to say.

In a way, it is analogous to the difference between sending in a check to the treasury every month versus getting taxes deducted at source ( we can thank Milton Friedman for that ). While choice in terms of how much taxes to pay is limited, I believe the potential for a tax revolt is much higher in the former system.

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