Do tax cuts work?

September 25, 2010

David Cay Johnston, in an article on Tax.com, examines the question of how the Bush tax cuts worked out for the U.S. economy. Not so well, it turns out.

Total income was $2.74 trillion less during the eight Bush years than if incomes had stayed at 2000 levels.

Although the wealthiest segment of the population did far better, people on average earned less. By this aggregate standard, it is clear that the Bush tax cuts, as an economic policy, were a failure.

The conservative story line, of course, is that people always do better when the government takes less of their money in taxes. More money in your pocket, right? Unless as a result of these policies you are out of work, or taking forced fuloughs or pay cuts, or trying to pay for a medical crisis.

So why do tax cuts not actually work? Several reasons:

• The Bush tax cuts greatly increased income inequality and concentration of wealth at the top, with the rich getting richer and the poor poorer. Most of the demand for goods and services comes from people in the low-to-middle income brackets, and this group simply has less money to spend. With reduced demand for output, businesses have no incentive to expand. The tax cuts temporarily put a few more dollars in people's pockets, but the sagging economy took that all back, and more. See for example
  Top 1% of earners get 20% of the money and Consumer Spending Key to Recovery in the San Francisco Chronicle.
• Wealthier people, given a windfall tax cut, tend to save or invest it, and not necessarily in the U.S.
• The Bush tax cuts helped fuel the growth of the financial sector of the economy so that money poured into arcane financial products such as CDOs. This happened at the expense of the sector that produces tangible goods and services. The "business of America," it turns out, is no longer business, but gambling. Preferably with other people's money. This was not restricted to Wall Street. Average-income people gambled that the value of their houses would continue to go up.
• Average-income people made up for their reduced income by borrowing more, a stopgap measure that blew up in 2008.
• Government does provide valuable services in the common interest (yes I know, many people don't believe that), and, in the process, spends money and puts people to work. This pumps money back into the economy and raises overall demand. Taxes are a necessary means to fund government services, especially at state and local levels, where deficit spending is much more restricted than at the federal level. Tax cuts and service cuts translate into income cuts.
• States also made up for reduced income by borrowing more, but after several years of collapsing revenues, that is no longer an option.
• Tax breaks to corporations do increase investment, but don't necessarily create more or higher-paying jobs. Given a tax break, a corporation might invest the money in automating processes or outsourcing production to countries with much lower labor costs and weaker environmental standards. See for example this article by Robert Reich. Thus corporations make higher profits, while domestic wages are pushed down.
• The private sector, left to itself, will generate investment and economic activity, but in the worldwide economy. Corporations' primary allegiance is to their stockholders, not to a nation or state.  Private businesses exist to maximize profits, not to meet social or national goals such as creating good jobs or protecting the common environment or investing in public infrastructure or providing security. It is up to government to look out for the common interest, and taxation is one of the main tools government (that's us!) can use to allocate the resources needed to achieve these common goals. Transnational corporations cannot be counted on to allocate resources in the common interest.

Johnston's article is worth a careful read. The ideology of cutting taxes has become a political sacred cow, with even Democrats fearful of challenging the notion that taxes can only go down. Or the notion that a failure to renew "temporary" tax cuts amounts to "raising taxes". (See, for example, Governor Schwarzenegger's attack on his predecessor for ending a "temporary" reduction in vehicle license fees.)

The conventional wisdom is that taxes can only go down, never up. The only problem, as Johnston makes clear, is that it doesn't work — it hurts the economy. If you disagree, read his article and let me know what is wrong with his argument.

Yes, taxes are painful, and a tax cut may provide a nice windfall. But in the long run, people are better off if the economy as a whole is functioning at full capacity and providing better jobs. Which would you rather have, a job that paid $3,512 more a year, or a couple hundred dollar tax cut at your present salary? That is the tradeoff Johnston describes in his article.

Robert Reich, on his blog, covers many of these same issues.

You might also want to check out David Cay Johnston's book Perfectly Legal, in which he describes the inner workings of the IRS and the byzantine federal tax code. You might be surprised at how the tax burden is distributed — who pays and who does not, and how the tax system has been rigged to enable "perfectly legal" ways to shift the tax burden onto someone else's shoulders.