Wednesday, September 10, 2008

Taxes and their Effects on the Economy

By Christopher Espinal

I have to start off with this lame introduction: tax policy is one of the most highly politicized tools of local and national government. Everyone thinks the solution to the nation's biggest problems are cutting or raising taxes on the privileged cohort of American society. Fiscal conservatives believe that cutting taxes can actually lead to more revenues and liberals think that raising taxes will lead to greater government funds. You can actually take some of the words in the previous sentence, mix them up, and create more fallacious statements.

The art of tax policy is actually much more delicate than some may believe. Hopefully the following economics tutorial on taxes will help us understand why this tool of fiscal policy may or may not assist political goals.

The Laffer Curve

Firstly, economic fundamentals are a must when discussing taxes. Suppose we have a supply and demand model and the government wishes to impose a revenue maximizing tax. Here is our market situation:

What the government really wants to do is impose a tax with the biggest square area which represents larger government revenues. If you look at the picture carefully, the area of the box can go from small, big, and small again along the demand curve. This is a fundamental concept behind the main economic tool right wingers wrongly appreciate - the Laffer Curve. Here is what the infamous curve looks like in picture:

So why do right-wingers wrongly appreciate this tool: because it creates a greater incentive for government spending and intervention. If lefties want to make government grow at its quickest, they need to understand the theory behind maximizing revenues - not fiscal conservatives. Right wingers need to talk about pushing taxation to the left side of that revenue maximizing tax rate. People have an incentive to be more productive with a smaller government siege on their potential human capital.

It seems that the politically motivated religiously espouse ideas that accommodate, yup, just ideas- rather than reality. That's why fiscal conservatives get caught up in "lower taxation" and liberals the opposite, without realizing the true potential effects. My conspiracy theory is that Arthur Laffer knew this all along and secretly wants the US to emulate Europe as soon as possible. Just kidding, but it's important that people really know their science before using it to embellish their political debates.

Oh, we aren't finished with tax policy just yet. There's more!

Yes, People aren't that Stupid!

Remember that Permanent Income Hypothesis and Rational Expectations stuff? That applies to tax policy as well, which leads me a conclusion contradictory to the advice I just gave fiscal conservatives.

I will start off by saying that people assess their economic situation in the long run, as said by the PIH, and people also intuit activities that may disrupt their long run plans as said by RE.

Let's think of some things going on that everyday Americans feel will disrupt their future: borrowing trillions from overseas to fund huge projects as the War in Iraq and an increase in unbalanced budgets.

Just as people can rationally expect inflation from liquidity going out of control at the Fed, they will rationally expect a point in time when the US government will have to pay its bills - or the IOU's given to foreigners on interest.

Since people know that John McCain will want to remain in Iraq and the Middle East for quite some time,they know that McCain will continue to borrow beyond government revenues and further expand our unbalanced budgets. This means that a fiscal stimulus by cutting taxes will have very little to no effect on the economy in the long run - people will put their tax cuts in their bank accounts to prepare for future tax increases aimed at balancing budgets.

In other words, there may be no significant increase in consumption, and thus no shift in Aggregate Demand. Ronald Reagan's trick will not work this time. However, if people save their money it certainly improves the investment side of GDP - and probably the future productivity ofthe economy.

My point is the efficiency of a tax cut depends on government activity and it's relation to the magnitude of unbalanced budgets. The tax cut will create an incentive to limit government size as it will decrease revenues (assuming we are already on the left side of the revenue maximizing tax rate as Martin Feldstein suggests), but it will not help the economy in terms of a demand stimulus -which is usually the initial purpose.

Christopher Espinal is an economics student at the University of Chicago. He can be reached at

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