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Left-leaning
commentators always like to make fun of the Wall Street Journal op-ed
page and other such right-leaning outlets who are often quick to recommend a
tax cut in the face of virtually any economic problem. Whatever pops up, the
"rich people" are there with their tax cut plans. What a bunch of
sleazeballs! President Bush still gets a lot of criticism for cutting taxes
"for the rich" in 2003, although this was followed immediately by a
fairly nice bull market and economic recovery -- and a rise in tax revenues,
and a smaller budget deficit, if we ignore Iraq expenses.
Actually, a tax cut
usually is about the best thing a government can do, in virtually all
situations. Let's see what I mean.
What are some of the
other things governments typically do in a recession?
Mail out "tax
rebate" checks. This is not a "tax cut" even though it might
be labeled a "tax rebate." The label is unimportant. Functionally,
it is a "government check in the mail" no different than Social
Security or welfare payments. The effects are very transient. Also, this
tends to cost a lot of money.
Devalue the currency. This can
provide some short-term effects which might seem positive, but the end result
is further impoverishment. You can't devalue yourself to prosperity.
"Cut interest
rates." Interest rates would fall naturally, in something like a gold
standard system, to reflect the overall lower return on capital during a
recession. This impulse to "cut interest rates" via artificial
means is typically a masked desire to devalue the currency.
Raise taxes. This is
typically to "close the budget deficit." Some states are
considering this right now. The federal government is going to effectively
raise taxes, by "phasing out" the Bush tax cuts. This "raise
taxes to close the deficit" was a major cause of the Great Depression,
and also many other economic blowups throughout history into the 1990s. Usually,
government budget deficits aren't really that big a deal. The tax hikes to
"close the deficits" can be a big deal, however. Ironically, the
tax hikes often cause so much economic deterioration that tax revenues fall
rather than rise, and the deficit gets bigger! This is especially true when
the recessionary effect of the tax hikes causes further pressure on the
government for welfare-type spending.
Welfare spending. Today's welfare
spending, such as food stamps or unemployment insurance, are usually welcome
in an economic downturn. However, they typically do little to resolve
whatever caused the economic problem in the first place. Also, the
combination of increased spending and depressed tax revenues (due to
recession) tends to lead to a bigger deficit, and thus calls for higher
taxes.
Public works
spending. Military-related spending often ends up in this category as
well. The idea is to create jobs via government funding. This is a
welfare-type activity, and typically does little to resolve the underlying
cause of the economic difficulties. Also, it tends to be very, very
expensive, which results in "raise taxes to balance the budget"
arguments. The effects are usually transient.
Reduce government
spending. Usually governments are rather bloated anyway, and what better
excuse to go through a downsizing than a recession? If there is a problem
with this, it is that it piles government unemployment on top of
private-sector unemployment. It would be much better to slim down the
government during the boom (OK, that never happens), when government workers
could easily find new employment in the private sector. Maybe if a government
reduced spending policy were paired with something positive, like a tax cut.
So, you see, what
else are you going to do besides cut taxes? A tax cut, in a
recession, has some advantages:
If the recession was
caused by a tax hike, at least in part, a tax cut is an excellent solution. Herbert Hoover raised
the top income tax rate in the United States from 25% to 63%, plus additional
taxes on inheritances and businesses. This definitely made the situation
worse. Much worse! A good solution for Roosevelt would have been to go back
to 25%. Yes -- sometimes it is that obvious. In 1997, Thailand's government was pushed by the IMF to raise its sales tax to 10% from 6%, to
reduce the looming budget deficit. (Thailand's government had run budget
surpluses for years, and had very low debt, but the economic crisis caused by
the currency crisis affected revenues. The IMF knuckleheads keep pulling the
same Herbert Hoover routine over and over.) This produced no positive
results, so the Thai government thought about it a bit, and moved the sales
tax back to 6% in 1998. See -- it's not really that hard.
If the economic
problems have a weak-currency component, a tax cut would help the currency to
rise. Especially in emerging markets, where a lot of financing can be in
foreign currencies, economic problems often have currency weakness as a
component. A significant tax cut -- such as the East European-style flat
taxes -- would have a meaningful currency-supportive effect, in addition to
their positive effects in allowing greater economic expansion.
If the economic
problems have little to do with taxes, a tax cut would still be one of the
most effective ways of inducing a stronger economy. The present
problems in the U.S. don't really have a tax hike component, although they
may in 2009 once there is Democratic leadership in Washington. However, if we
look at the list of options above, I would say that a meaningful permanent
tax cut is one of the best options a government has to create more economic
activity. What would the U.S. be like if we enjoyed a Hong Kong style tax
system, with a 15% top income and corporate tax rate, and no taxes on
interest income, dividends, capital gains, or inheritances? It would probably
be a lot more healthy economically. If something is good for an economy in
the long run, like a sensible tax system, then it is probably good in the
short run as well. Vladimir Putin passed Russia's 13% flat tax in 2000, the
depths of a decade-long economic catastrophe. The result: POW! Galloping
economic growth -- the most since before the First World War! -- and
galloping tax revenues. This was no fluke, since many other moribund FSU
countries did much the same thing in 2001-2008, with much the same results.
June 30, 2007: East Europe's Flat Tax Revolution
A tax cut works, not
because of "putting money in people's pockets" or some such
nonsense, but because it lowers the barriers to transactions in an economy. An
economy is all about cooperation, and if there are high taxes, people are not
able to cooperate productively. Russia's 13% flat tax worked because it
removed all the "internal trade barriers" caused by taxes.
A tax cut helps
dispel the urge to raise taxes. One of the most destructive things a
government can do is to raise taxes in a recession. There might not be enough
political will to cut taxes dramatically. However, if there is even an eeny
beeny tax cut, too small to make any real difference, that would at least
tend to cancel any urge to raise taxes. So, cutting taxes can be a useful
political exercise, even if it fails.
A tax cut helps
dispel the urge to devalue the currency. Once you've done what you can do
with welfare-type spending, the next thing a government typically reaches for
is currency devaluation. Much better to focus attention on a significant tax
cut.
A tax cut helps allow
a reduction in government spending. Of course a tax cut
alteration isn't spending itself, although it is often referred to in this
way. What I'm getting at is: as an economy benefits from a tax cut, people
are better off, and thus there is less pressure on the government to "do
something," which often means welfare-type spending. One way that a tax
cut can help lead to better government financies is not only that a healthy
economy produces more tax revenues, but it is much easier to reduce other
spending when the private sector is going strong. If Japan's government had
been aggressive about cutting taxes in the 1990s, for example, there would
have been much less pressure to try to keep idle hands busy via the
hyperexpensive public works projects. (Whenever economists talk about
increasing government spending in terms of "percentage of GDP,"
hold on to your wallet!) To take another example, Margaret Thatcher started
her term in Britain in 1979 with a big tax cut, which eventually lowered the
top income tax rate from 83% to 40% and the corporate tax from 52% to 35%,
eliminated a 15% investment income surcharge, reduced the capital gains tax
rate from 75% to 30% and indexed it to inflation. It was only after she got
the private economy up and running again that she engaged in rolling back the
socialist state, which had evolved largely as a reaction to the ill health of
the private sector.
Today's economic
problems in the U.S. are mostly due to the previous credit binge. The natural
response to this is government bank recapitalization. The U.S. government is being pressed down this path by events as it is, just as other governments (Japan, Britain, France, Sweden, Mexico, Korea) have been pressed down this path in the past. Government
spending -- the "tax rebates," welfare, military spending,
homeowner bailouts, etc. -- has gone about as far as it is going to go. What
comes next? Unfortunately, really bad economic problems usually have, at
their root, high or rising taxes and monetary instability. It looks like we
have both coming up. Bernanke is obviously a devaluationist at heart, who
believes that the Great Depression was caused or worsened by the fact that
the world's major governments -- every one of which devalued their currency
-- did not devalue quickly enough or dramatically enough. The Democratic
Party is anxious to rub out whatever tax-cutting legacy was left by Bush,
plus pile on some additional taxes. The real crunch may come in a year or
two, when the economy may be really coming apart and tax revenues at
governments are sagging badly. A typical Democrat response would be: more
devaluation, more government spending, and more tax hikes to supposedly pay
for the spending.
This was not always
the case. Roosevelt made arguments for a tax cut in the 1932 elections -- and
promptly forgot them afterwards, although his Secretary of State Cordell Hull
did make many efforts to reduce tariffs worldwide. John F. Kennedy enacted a
big tax cut, on which the later Reagan tax cut was modeled. In 1974-1975, a terrible recession, the Democrats tried to push through a significant tax cut, and were
indeed successful although the result was much watered-down (by Republican
opposition). Jimmy Carter campaigned in 1976 on vague tax-reform promises
(and did nothing afterwards).
The Republican's 1977
Kemp-Roth bill proposed what was essentially a carbon copy of the Kennedy tax
cuts. This was narrowly defeated in the Democrat-controlled Congress, but it
was revived in 1978 by Democrat Sam Nunn as the Nunn Amendment, and passed
both houses of Democrat-controlled Congress. Bill Clinton promised a
"middle class tax cut" in the recession in 1992, and soon forgot
all about it. Now we have Obama making some suggestions about lower taxes for
lower incomes. I'm all for a $40,000 per adult standard deductible. There are
better systems (look at the East European examples), but that would help and
it's something the Democrats might rally around. It would help get their mind
off tax hikes at least.
It really irks
Democrats when you remind them that John F. Kennedy was a tax cutter. And, it
really irks Republicans when you remind them that Kennedy's tax cut plans
were opposed by the Republicans, who were obsessed with "balancing the
budget". A decent book on the Kennedy tax cut was written by Herbert
Stein, called The Fiscal Revolution in America. It was published
in 1969, and begins with this paragraph:
Herbert Hoover
recommended a big tax increase in 1931 when unemployment was
extremely high and a large budget deficit was in prospect.
John F. Kennedy
recommended a big tax reduction in 1962 when unemployment
was again a problem, although a much less serious one, and a large budget
deficit was again in prospect.
The contrast between
these two Presidential decisions symbolizes the revolution in fiscal policy
that occurred in the intervening thirty-one years. . . . Hoover proposed a
tax increase both to raise employment and balance the
budget. Kennedy proposed a tax cut both to balance the
budget and raise employment. [Stein's emphasis.]
And what happened?
The Kennedy tax cut was passed posthumously by Johnson in 1964. An economic
boom commenced, and in 1965, the government was on track to run a budget
surplus -- if it had not been weighed down by Johnson's Vietnam expenses.
Surprised? Vladmir
Putin wouldn't be.
Nathan Lewis
Nathan Lewis was
formerly the chief international economist of a leading economic forecasting
firm. He now works in asset management. Lewis has written for the Financial
Times, the Wall Street Journal Asia, the Japan Times, Pravda, and other
publications. He has appeared on financial television in the United States, Japan, and the Middle East. About the Book: Gold: The Once and Future Money (Wiley,
2007, ISBN: 978-0-470-04766-8, $27.95) is available at bookstores nationwide,
from all major online booksellers, and direct from the publisher at
www.wileyfinance.com or 800-225-5945. In Canada, call 800-567-4797.
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