Thursday, February 18, 2010

Do tax cuts starve the beast?

I was listening to Jason Lewis (a nationally syndicated conservative radio host) and he mentioned that if our deficit were used to fund tax cuts he would be OK with that. So it got me thinking, are tax cuts stimulative? Are they any better at stimulating the economy than spending?

The economy is an evolutionary economic machine. It grows naturally because brilliantly ordinary men and women are constantly finding ways to do more with less. Efficiency allows labor to find new work, to create new products and services, and to make us (presumably) happier. The free market facilitates this process through private enterprise and government, i.e. the anti-free market, hinders it. So for our economy to grow, i.e. the pie to get bigger, we need to embrace private enterprise at the expense of government. Otherwise, government gets larger while the pie gets smaller.

This leads to the relevant issue. The only thing that matters in terms of stimulating the economy (growing it) is what percentage of the pie is public versus private. Too much public crowds out the private, and the rate of growth slows down. Government spending is really the only relevant issue. Spending, regardless of how it is financed, determines what percentage of the economic pie the public sector is.

Government borrowing increases spending; it increases the share of government and this retards overall economic growth. What about tax cuts, do they stimulate? The reality is that tax cuts affect the financing side of the balance sheet, and we know from Modigliani and Miller that financing does not affect the real value of the economy. Therefore tax cuts are not stimulative and any correlation must be attributed to some other reason. My personal theory is that tax cuts shine a light on government spending. And even though this may not starve the beast as intended, it at least causes us to look at what we are feeding him.


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