Let’s Talk Taxes

Seemingly every 2-4 years, the Federal Government starts talking tax reform.  The same talking points are repeated over and over: high tax, low tax, red tax, blue tax.  But from an economic standpoint, taxes are much more subtle.

The standard economic story of taxes is fairly simple: as the price of something goes up (in this case, the price increase is due to taxes), you get less of it.  Higher taxes on labor (income tax, payroll tax, etc) discourage labor.  Higher taxes on cigarettes discourage smoking.  Therefore, many economists argue, taxation should be as low as possible.  Therefore, tax cuts can stimulate economic growth.

However, taxation does go to support government and institutions like stable property rights (under which I am classifying law enforcement and national defense), courts, and the like.  Other economics argue these institutions encourage economic growth, so taxation should be relatively high to fund and develop these institutions.  So tax hikes can stimulate economic growth.

Both arguments are reasonable and not mutually exclusive.  There is likely some optimal level of taxation necessary to promote desirable institutional development without being a net drag on the economy.et’s say that the economy is beyond that optimal point of taxation, that the current level of taxation is too high and is a net drag on the economy.  Does it immediately follow that taxes should be cut to stimulate growth?

Let’s say that the economy is beyond that optimal point of taxation, that the current level of taxation is too high and is a net drag on the economy.  Does it immediately follow that taxes should be cut to stimulate growth?  I argue no.  If taxes are cut without regard to spending, that is taxes are cut and deficits emerge, then it won’t do much to stimulate growth.  This is because people are rational and forward-looking.  If taxes drop and deficits rise, then people will realize that, at some point, those deficits will need to be covered, either by higher taxes in the near future, or by government borrowing, which means higher taxes down the road.  People will begin to prepare for these higher taxes by saving more in the meantime knowing they’ll have a higher tax bill coming.  In short, there would be little (if any) effect on the economy from the tax cut; it’ll be no different than if there had been no cut at all.

However, if the tax cut were permanent, that is coupled with a cut in spending so that there is no deficit, then the cut would likely have a more positive effect.  Knowing (to the extent they can) that taxes won’t rise means they see their higher amount of kept income not as a temporary thing, but as a permanent change.  The tax cut would have a more stimulative effect on the economy.

When discussing taxation, it’s important to remember that deficits matter, too.  A tax cut that only generates deficits won’t have the same effect as a tax cut that does not generate deficits.

4 thoughts on “Let’s Talk Taxes

  1. It is one thing to observe that people are “forward looking.” It is quite another to conclude that this means they have some reasonably accurate system of saving for future tax increases. They don’t.

    Few people even save as much as they should for their own retirements. And that’s a much easier calculation than future tax increases. Even our very best economists can’t predict the amount and timing of future tax increases.

    Furthermore, today’s deficits are probably likely to be funded as much or more by future inflation than future tax hikes. Looking forward and seeing inflation might just as easily cause people to save less and spend more at today’s lower prices.

    Current deficits do stimulate the economy in the short term. It’s not necessary or wise to deny that in making an argument that they are bad policy.

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    • Your criticism is a good one, but let me plead “theory” here. I am making a theoretical argument. I have made certain simplifying assumptions to make the point clearer. However, I feel that loosening some of these assumptions doesn’t weaken my case. If people expect taxes will rise in the future, they will save some of their income to prevent paying higher taxes (see, for example, Roth IRAs). Will they save perfectly? No. But I doubt we will not see the temporary tax cut be stimulative the same way a permanent tax cut would be.

      I’m making a Ricardian Equivalence argument here, which I will admit not all economists accept. if you’re interested, there’s a great debate between Robert Barro (pro-Ricardian Equivalence) and Martin Feldstein (anti-Ricardian Equivalence)

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