Can Tax Cuts Grow the Economy Without Spending Cuts?

Frank Shostak recently wrote an article for the Mises Institute titled “Tax Cuts Without Spending Cuts Won’t Grow the Economy“.

I wholeheartedly endorse the spirit and main point of his article, but I do want to dig deeper into the main argument.

I recently wrote a post about the Trump/ Republican tax plan.  There are some positive aspects about it, along with some negative ones.  In some ways, it really is like rearranging the deck chairs on the sinking Titanic, except that some will make out better than others.

In my post, I wrote the following, “But this tax proposal does not really deal with our high tax burden. The reason is because it doesn’t address spending. Regardless of whether this thing passes, the federal government will still be spending about $4 trillion this year. This is money coming out of our pockets one way or another.”

This is basically the whole point of Shostak’s article.  Still, I might take exception to the title of his piece, along with one sentence within the article.  He writes, “Contrary to what the followers of supply-side economics claim, it is not possible to strengthen economic growth by lowering the tax rates whilst keeping the size of government outlays intact.”

He is basically correct in this, but we have to make a caveat.  This is only true to the point where tax cuts are not so confiscatory as to severely hamper economic activity.

While I do not endorse much of what supply siders say, I do think they are correct to a certain extent on the Laffer Curve.  It is not anything brilliant that Arthur Laffer came up with.  It simply says that there is some tax rate (or tax rates) in which tax collections to the government will be maximized.  This is easy to confirm when you take the rates to either extreme.

If tax rates are zero, then the government is not going to collect anything, unless it is voluntarily handed over.  If marginal tax rates are 100%, then almost nobody is going to work above the income threshold that puts them in this bracket.  They are not going to work for free.  Of course, in a country of 325 million people, you can almost always find a few exceptions.  There would be a few people who would work just to send all of their earnings over to the government.

The point is, tax rates at zero and 100% would yield the government virtually nothing.  Therefore, the maximum collections would be somewhere in between these two rates.  The Laffer Curve doesn’t claim to know the exact rate, although it doesn’t stop us from speculating.  The maximum tax collections might happen at 20% or 80% or whatever.

Therefore, if marginal tax rates are really confiscatory so as to severely hamper production, then a cut in rates could actually yield more tax collections for the government.  We must also figure that taxes could be cut so as to yield approximately the same tax collections.

For example, let’s say the government could maximize its revenue with a top marginal rate of 50% to collect $4 trillion.  Let’s say the current top rate is at 60% and the government is collecting $3.5 trillion.  Let’s also say that the rate could be lowered to 42%, which would yield the same collections as the 60% rate due to the increased economic activity.

Therefore, in this example, the government could cut the top rate from 60% to 42% and it would still yield the same revenue of $3.5 trillion.  In this scenario, it would be hard to argue that tax cuts would not be beneficial for economic growth, even if government spending remained the same (regardless of whether the government is running a deficit).

I don’t want to overemphasize the Laffer Curve as is done by the supply siders.  Of course, at least for any libertarian, the goal is not to maximize the government’s collection of taxes.  In addition, not knowing which side of the curve we are on, it is hard to justify tax cuts on the basis of increased government revenue, or even a revenue neutral tax cut.

The major problem here, which is rarely discussed by supply siders, is the existence of a central bank that can create money out of thin air.  This enables the government to run high deficits and accumulate huge amounts of debt that wouldn’t be possible otherwise.  If you cut taxes at the state or local level, you really can starve the beast.  In the case of the federal government, they can just issue more debt.

In addition, the whole idea of increasing government tax collections by decreasing tax rates is clouded by monetary inflation.  When tax cuts were pushed and implemented by the Reagan administration in the early 1980’s, there was ultimately an increase in tax collections.  (Despite what the left often claims, the larger deficits/ debt were not a result of tax cuts.  They were a result of increased spending.)

But the increase in tax collections was also partially a result of the monetary inflation.  The Fed had a tight policy in 1979 and the very early 1980’s, but the Fed started to loosen up again.  In order for government tax revenue to increase that much over a period of time, there almost has to be monetary inflation.

To summarize, I do think it is possible to strengthen economic growth by lowering tax rates in certain situations, even if government spending remains intact.  But that is not likely the scenario we are in now, with the possible exception of the corporate tax rates.  The corporate rates are very high, especially as compared to the rest of the planet, and lower corporate rates could bring more businesses to be headquartered in the United States.

Still, I agree with the general spirit of Shostak’s article.  We would see much greater economic growth if the government were to significantly cut spending.  Government spending diverts real resources away from their most efficient use as determined by consumer demand in the market.  Government spending is a misallocation of resources that makes us poorer.

While seemingly everyone is discussing tax cuts, we desperately need government spending cuts.  That is what would significantly improve the lives of middle class Americans.

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