Tax Cuts the Solution to Everything

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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.

Nathan Lewis is the author of Gold: The Monetary Polaris (2013), and Gold: The Once and Future Money (2007).  

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