- Jul 29, 2001
Found this in a weblog..
Tax cuts encourage investment
The Truth Part 1 - Tax cuts always decrease investment
For example, let's say the government gives a wealthy person a $100 tax cut. Now, the wealthy person will spend some of the $100, put some of it in non-investment financial instruments like cash and his checking account, and he will invest some of it. Say he invests $50. The Republicans then proudly say, "Look, the tax cut created $50 of investment." But were did the $100 come from? The government had to borrow it from someone. Say the government borrowed it from the same wealthy person. Were is the wealthy person going to get the $100 from? From selling his other investments. So in this case, the amount of money in our simple example that the weathy person has invested decreases by $50. Because the government has to borrow from investors to make up for the reduced amount of tax revenue, a tax cut will always decreate the total amount of money invested.
The Truth Part 2 - Tax cuts discourage long-term investment
What has happened recently (the 90's and later) is that bond investors respond to a decreasing government deficit by decreasing long-term interest rates and respond to an increasing government deficit by increasing long-term interest rates. There are economic theories that suggest why this should happen and there are economy theories that suggest this shouldn't happen, so I am going to go on recent experience.
Long-term interest rates are a major factor in whether corporations make long-term investments. Let's say a corporation is considering a project that, when the rate of return is adjusted for risk, pays back 7% over 30 years. If the long-term interest rate is 6%, the company will make the investment. If the long-term interest rate is 8%, the company won't do it. Part of the reason there has been little business investment in 2002 is that the long-term interest rates are up.
The Truth Part 3 - Tax cuts discourage foreign investment
This is weak, but could become important. Foreigners invest in the US because they think the economy is well run and will produce better long-term returns than other countries. If the US government does things that give foreign investors more confidence, then more foreign investment will come into the US. The amount of foreign investment money dwarfs the amount of money involved in a tax cut.
Now here is the weak part - one could argue that foreign investors will be spooked by a government that seems to have lost control of the deficit. There are lots of other factors that drive foreign investor confidence such as the reliability of company financials. But according to a recent Krugman column, all of the factors are pointing in the wrong direction and foreign investors have started pulling their money out of the US.
Tax cuts for high-earners encourage them to work hard and longer
The Truth - Tax cuts encourage high-earners to work less
Let's say I am a consultant who works 48 hours a week at a $100/hour, with an effective tax rate of 30%. That means my net pay is $3,360 per week. Let's say that my effective tax rate drops to 20%. I can now earn the same net pay in 42 hours a week. By economic theory, because I value free time, I will substitute some of the hours I was working for free time. With the new tax rate, I will work somewhere between 48 and 42 hours per week based upon how much I value free time.
Tax cuts for the wealthy encourage entrepreneurship
The Truth - Tax cuts for the wealthy discourages enterpreneurship
The Republicans say that tax cuts for the wealthy encourages entrepreneurship because people will work harder to hit it rich. The number one thing that keeps people from starting their own company is a lack of initial capital. I have already discussed how tax cuts decrease the amount of investment money, and that will make raising initial capital harder. I have already discussed how tax cuts drive up long-term interest rates, and higher long-term interest rates make starting a new company more difficult. Now part of that initial capital usually is the entrepreneur's own money. To raise that money, they have to save it while working their current job, which is probably not over $100K per year. By shifting the tax burden away from the wealthy (which is what tax cuts for the wealthy does), it slows the rate of capital accumulation of the non-wealthy and therefore decreases their ability to raise the initial capital they need to start a new business.
Reduced capital gains tax encourages entrepreneurship
The Truth - Reduced captial gains discourages entrepreneurship
Capital gains tax applies to all investments, risky or not. Most entrepreneurs draw their money out of the business in a form that is taxable as salary, not capital gains. The only way an entrepreneur can draw money out of their business in a form that captial gains would apply is if they sell their business or if they take their business public and then sell part of their stock in the business. So, let's say you have $1,000,000 and could invest it in stocks or start your own business. The stocks earn a 6% appreciation and a 28% capital gain. You could pay yourself a $60,000 salary (6% of 1,000,000) which would taxed at 40%. The stocks would earn you a net $43,200. The job would earn you a net $36,000. The larger the spread between captial gains tax and salary tax, the greater discouragement to entrepreneurship.
Tax cuts for the wealthy is the best way to grow the economy
The Truth - Tax cuts for the poor is the best way to grow the economy
Republicans say that tax cuts for the wealthy is the best way to grow the economy because they will wisely invest the money and therefore create new jobs. I have already discussed how tax cuts decreases the amount of money invested. I have already discussed how tax cuts for the wealthy actually discourages entrepreneurship and encourages high-earners to work less. Another problem with giving money to the wealthy is that they don't need anything so they are slow to spend it. Give it to someone who is poor and they will spend it immediately. As most people spend their money in their neighborhood and Americans tend to live in areas according to their wealth, the poor will spend their money in poor neighborhoods where the people who receive it will in turn immediately spend it. This means that the amount of economic activity generated by a tax cut to the poor is much greater than the economic activity generated by a tax cut to the wealthy. Increased economic activity means more jobs and more tax revenue. So tax cuts for the poor will generate far more jobs than the equivalent tax cut for the wealthy.
I am not an economist and have only taken economic classes while getting my MBA. But most of this is common sense.