The Double Benefit of Tax Cuts
In their debate on economic policy last month, every Democratic candidate for president called for rolling back all or part of George W. Bush's tax cuts. All politics aside, and with the economy showing signs of recovery, perhaps now is the right time to revisit the rationale behind tax reductions and what seems to be an excessive fear of budget deficits.</br></br>Proposals for tax reductions during periodsof a weak economy are inevitably followed by discussion of the stimulus effects that such cuts will have on economic activity over the next year or so. Less often is the focus on the more important issue, which is whether a tax cut helps in the long run. Tax cuts make sense for two reasons. First, government spending responds to tax revenues, so that lower revenues imply lower government spending. Second, economic growth depends on both human capital and physical capital, and investment in human capital, as well as physical capital, is responsive to tax rates. Consider each in turn.</br></br>Like any company or household, government spending is constrained by its revenue. The sum of present and future public spending, discounted by the rate of interest on government bonds, must equal the sum of present and discounted future tax revenues. This government budget equation has been recognized by economists since the pioneering work on taxation by economist David Ricardo in the early 19th century. Typically, economists take government spending as given by the needs of society, and assume that taxes, including taxes on money balances generated by inflation, adjust to this spending in order to balance the government budget equation.</br></br>Yet economic theory and empirical evidence suggest that spending often adjusts to available tax revenue rather than the other way around. Government spending responds to the ongoing political battles between taxpayers and the interest groups that benefit from government spending.</br></br>Developments in the federal budget since the early 1980s illustrate the dependence of spending on tax revenue. The Reagan tax cuts of the '80s helped promote longer-term growth, but they also increased federal deficits and subsequent interest payments on the debt. The Bush tax cuts will also help future growth, and possibly have already begun to stimulate the economy