Should the government cut income taxes to stimulate the economy, as John McCain and the Republicans have suggested? No, it shouldn't. Take a look at a graph Paul Krugman put on his blog a while back:
According to the graph, it would actually make more sense to raise taxes on rich people than it would to cut them, if your purpose is to fight a recession and stimulate the economy. When Bill Clinton and a Democratic Congress raised the income tax rates of the wealthy in 1993, the immediate result was seven years of strong economic growth. After the Republicans slashed the income tax rates of the wealthy in 2001, the immediate result was economic decline, followed by one the weakest economic 'recoveries' on record. Employment and economic activity began to pick up significantly only after the immediate effects of the tax cut had worn off.
To understand why the historical record flatly contradicts Republican claims re: tax policy, it helps to understand a few basics about the economy. Economic recessions are times when unemployment grows, businesses lose money, and measurements of the economy's performance show a significant downturn. The measurement that gets most of the attention during a recession is the GDP, i.e., the Gross Domestic Product.
The GDP is a measurement of economic output, but it is also more directly a measurement of total SPENDING in the economy. GDP numbers are derived primarily from sales figures, the sales of goods and services. When the economy is in a recession, sales drop because there is a decline in total SPENDING. When spending drops, people lose their jobs. If you want to eliminate unemployment and pull an economy out of a recession, then it is absolutely necessary that you increase the amount of money that is being SPENT in the economy.
No "economic stimulus package" can be effective unless it leads directly to an increase in total spending in the economy. Does an income tax cut---by itself---cause an increase in total spending to occur? No it does not. An income tax cut by itself cannot produce a net economic stimulus. This is because a tax cut by itself must necessarily be accompanied by a reduction in government spending. Governments cannot spend money that they do not have, so any time a government reduces the amount of taxes it collects, it is automatically depriving itself of the money it needs to continue spending as it had. Unless something else is done a tax cut automatically forces the government to reduce its spending. The 'something else' that usually enables governments to continue spending is called borrowing.
When governments borrow money, the economic result is always the same: strong, direct economic stimulus. This is because money that had been taken out of the economy (saved) is then spent by the government. In contrast, an income tax cut by itself takes money that would have been spent by the government and gives at least some of it to savers who will remove a portion of the money from the economy. The only time an income tax cut by itself is not contractionary is when all those receiving a tax cut go out and spend all of it. When that happens, the decrease in government spending is exactly matched by the size of the increase in consumer spending. And when that happens, the effect of the tax cut is neither expansionary nor contractionary for there is no change in total spending. That's the best you can hope for if you cut taxes and pay for them with spending cuts.
Of course, it is far more likely that at least some of the taxpayers who receive a rebate check from the government will either save some portion of it or they will use some of all of it to pay off debt. If/when either of those things happen, the net result is a withdrawal of money from the economy as a direct result of the tax cut. This, because the drop in government spending that would occur would be greater than the increase in consumption spending that would occur. When an increase in consumption spending fails to make up for a decline in government spending, the result is a net decline in total spending and deteriorating economic strength. That, ultimately,is why income tax cuts by themselves are almost always contractionary.
The only reason why George Bush's income tax cuts for the wealthy in 2001 did not throw the economy into a deep depression is because he also did something else besides cutting taxes that actually provided some stimulus to the economy. He borrowed massive amounts of money in order to maintain government spending levels and to finance his incompetently conceived and executed War on Terror. It took all of that borrowing and historically low interest rates to keep the economy from collapsing as a direct result of the Republican tax cut.
If the tax cuts had been given only to poorer people who would have spent all of it, the effect would not have been as contractionary. But because the Republicans gave most of their tax cut to America's wealthiest people, larger amounts of money were removed from the economy, requiring even more borrowing in order to avoid disaster. Saving is the very last thing you want people to do with a tax cut that is intended to stimulate consumption, so why would you give any of a tax to wealthy people when the economy needs stimulus, not more saving?
Utterly unappreciated by the media is the simple economic truth that tax increases are a true stimulus to the economy, if some of the money collected in taxes comes from people who would have saved it, instead. When/if that happens, money that would have been removed from the economy by the savers would get spent by the government, instead. That is a net increase in total spending, which is economic expansion, any way you look at it.
In the coming days and weeks and months, Democrats will be pressed to explain how they are going to pay for the stimulus that the economy needs. The answer they should be giving is that they intend to increase taxes on the wealthy in order to pay for the stimulus that Main St. needs while Wall St. is experiencing the Mother of All Shakeouts. Unfortunately, the Republican Party has been so successful in promoting its economic mythology over the years, many Democrats have come to come to accept many of their flawed premises. How incredibly sad for us. Let's hope that we can start to change that situation this election cycle...
Economic Justice
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