Monday, October 1, 2012

Tax cuts: A viable alternative to addressing the real root of the global crisis?

            The world and many countries and regions within, have been in economic crisis mode for half a decade now.  I often pointed out on the blog and in my book that something fundamental changed in the middle of the last decade.  The economic environment is no longer what it was; therefore the set of ideas contained within the left/right ideological camps no longer hold relevance when it comes to addressing our problems.  We need new ideas urgently, but as long as the old ideological divide continues to solidify, no relevant new idea can ever come to the forefront, because nothing of actual practical applicability can ever pass the ideological purity test on either side, therefore we remain stuck recycling old ideas, many of which did not necessarily work all that well in the past in the first place, yet we continue to receive the same remedy, even though the sickness is something completely new and as I shall ilustrate through my example, completely resistant to the current arsenal of remedies offered by our politicians.

Tax cuts as a way to restart the economy:

            With the US elections approaching, we have one of the most important, globally significant economic policy decisions being put on the ballot for the US electorate to decide.  They have the choice of the current administration versus choosing a new one, which has as its main economic policy approaches a belief that cutting taxes is the way to get the economy back on track.  I recently had a conversation with someone about this, and it really helped me understand why it is that ideologically right leaning people may believe this to be an unquestionable fact.  He pointed out to me that the Reagan tax cuts helped the US economy recover from a dismal economic situation left by the Carter administration.

Some background facts on the real effect of tax cuts:

            It is true indeed that there was a recovery during the Reagan era, and we might be tempted to jump to the conclusion that tax cuts are the answer to why the recovery happened.  I disagree with that notion, because there is one other important aspect we need to remember.  Taxes were cut, but the deficit also ballooned as a result.  There were no significant spending cuts to offset the decrease in revenues collected.  In effect the US economy received an infusion of money, acquired through debt issuance.  In fact, inflation adjusted deficits were more than doubled in the 1980’s compared to the 1970’s.

$17    Billion
$130  Billion
$129  Billion
$77    Billion
$28    Billion
$226  Billion
$297  Billion
$203  Billion
$208  Billion
$128  Billion
$206  Billion
$200  Billion
$304  Billion
$479  Billion
$409  Billion
$453  Billion
$463  Billion
$302  Billion
$301  Billion
$282  Billion

(See endnote for reference)[i]

            As we can see from the chart, the Reagan administration can be summed up as one where deficits doubled from the previous administration.  Such an infusion of money into the economy could only have one effect and one effect only, and that is to stimulate spending.  We should also make note of other factors that had little to do with Reagan and his presidency, but did contribute to economic stability.  Inflation moderated considerably, giving a boost to the economy as well.  In 1980, inflation was at 12.5%, and it fell to 3.8% by 1982.

The effect of such a tax cut in today’s context:

            The deficit for 2012 is estimated to come in at over one trillion dollars.  There is therefore no room for more deficit spending to stimulate the economy.  The tax cut would have to be accompanied by budget spending cuts, otherwise the US might be greeted with an unpleasant surprise in the form of an earlier than expected visit from the bond vigilantes, who might come to lynch US government debt.

            Some may claim that this would still have a stimulative effect even if government spending were to be cut, because the multiplier in the economy of private investment is greater than that of government spending.  I will not get into the debate of what is the multiplier effect of each form of spending.  I will reserve a comment I want to make on the effect that cutting the social safety net can have on consumer spending a bit later.  I will take the assumption from the right that private investment will yield a greater multiplier effect than government spending for granted, and give it a multiplier effect of x4, versus x2 for government spending.  In other words, a 1% of GDP increase in private sector investment should yield a 4% growth of GDP[ii].

Effect of a $100 billion per year tax cut accompanied by spending cuts:

            The simple math given the higher multiplier effect of private investment would lead us to the conclusion that the US economy would get a stimulative boost of $200 billion, given that cutting government spending by $100 billion would cut $200 billion out of the GDP, while boosting private investor spending by the same $100 billion per year would increase GDP by $400 billion.  Taking a closer look however we should realize that we can easily yield a very different conclusion if we look at the details.

            First off, the US Republican tax cuts would indeed mainly benefit the top 10% of earners, since they pay more income taxes.  Many of them are business owners, big and small and major shareholders, but not all of them.  A great number of them are actually high earning professionals such as doctors, lawyers, academics, engineers, financial analysts and many more who manage to earn a decent living doing what they do.  It is hard to argue that these people would in fact increase consumption by more than the resulting drop in consumer demand as a result of cuts made to benefits and services.  Poor people and lower middle class earners are more likely to spend on much needed goods and services than people who already have many of their basic needs met, and already have a healthy discretionary spending income.

            A doctor, who already makes $500,000 net per year, might be tempted to buy a second house in Tuscany, or a cabin in the pristine Canadian wilderness if given an extra $20,000 per year in the form of a tax break.  This might actually lead to the doctor spending far less in the US, given that he/she would be more likely to invest more money and time in the new property.  Similarly, other professionals earning in the six figure range might be tempted to take more leisure time in foreign lands, thus actually decreasing their consumption level in the US as a direct result of the extra money derived from the tax cut.  It is hard to gauge what percentage of the $100 billion tax cuts would go to this category of individuals, but my guess is that it would be a healthy portion, of perhaps as much as half.

            That would leave $50 billion in the hands of actual investors, so one might still be able to argue that while the tax cut would not have the $200 billion net GDP boosting effect originally assumed, it might still be perhaps $100 billion, therefore trickle down would work.

            I take issue however with the assumption that given an extra $50 billion per year to keep, investors would actually invest all of it and invest it in the US.  That might have been a reasonable expectation in Reagan’s time, but now with globalization in full swing, I think it would be outright foolish to expect this.  Some of that money would go to debt reduction and perhaps a further increase in personal income for the investors.  It is impossible to predict how much, but given that it is a well known fact that big companies are already sitting on piles of cash they refuse to deploy for the past few years, it is not unreasonable to believe that perhaps the lion’s share of that extra income would go on top of that pile of idle cash.  As for the money that will be invested, given the investment pattern of big companies in the last two decades, it is reasonable to assume that most of it would end up somewhere else, since building factories and other production facilities in cheaper environments is a sure way to boost profit.

            I also wanted to bring us back to the issue of the consumer demand effect that cutting benefits and services, the government currently provides, would have.  People are already feeling uncomfortable with the level of uncertainty in terms of job security, unforeseen investment losses and other financial issues.  Cuts to unemployment benefits or even to the food stamp program, could easily have a disproportionate counter effect caused by tens of millions of wage earners deciding to cut consumption drastically in order to be able to build a small personal safety net of their own.  The effect could add up to hundreds of billions per year, and a resulting recession could induce a spiral effect, where the resulting recession would cause people to cut more spending, thus increasing unemployment and uncertainty and more contraction.

            Going back the expected resulting investments stemming from the tax cut, we have to remember that the primary factor involved in investments is the expectation of consumer demand.  Current industrial capacity in the US is used at 79.3% according to the latest Federal Reserve figures.  It is 1% bellow long term average starting from 1972, so it is not disastrous, but it is a sign that consumer demand is still quite weak, and building more capacity is not warranted at the moment.  Some investment may be made in modernization, but that in the absence of growth in consumer demand might actually lead to job loss, because modernization usually leads to an increase in productivity levels, and a corresponding decline in labor demand.  Taking all these factors into consideration, it is fair to say that at the very least we cannot be certain what effect tax cuts would have on the medium term economy.  It is therefore disingenuous of right leaning people to claim that we should automatically assume that tax cuts would bring back the good times, which seem like an increasingly distant memory for many of the people affected since the 2008 economic downturn.


            When looking at ideology based ideas, I try to be as neutral as possible.  Anyone who ever read my work should realize by now that I do not adhere to political preferences.  I have been critical and supportive of both the left and the right whenever I felt that it was warranted.  For instance, I often voiced my opposition to the idea advanced currently by the Obama administration that investing in the green economy will give the US an edge, given that it is the future of technology and economics.  I believe that China’s policy of building massive capacities of coal powered plants, while only investing comparatively token resources in green tech will make them more competitive economically than any country focusing on trying to be voluntarily good global citizens.  A niche market for heavily subsidized electric cars is not the way of the future in my view (which I expressed in a previous article: Link).  A standardized global trade tariff, designed to promote sustainability on the other hand could on its own push for these green technologies to be applied worldwide, not just in niche markets, as I pointed out in my book.

            I mentioned that something fundamental changed in the middle of the last decade, which forever changed prospects for our economic future.  Few people are aware of this but in 2005-06 conventional crude oil reached a plateau in production, and it has not increased significantly since, despite sustained higher prices.  The only increase in liquid fuels came courtesy of unconventional sources, which only make up about 20% of total supply.  Some argue that the oil price spike of 2008 is what caused the great recession.  Many people argue against this, but let us be honest.  If there would not have been a deep recession in 2008, we currently would be in a situation where global oil consumption would have been outpacing supply for half a decade now, and the gap would most likely be widening.  Prices would therefore be unbearable right now.

            So let us think back to the proposal of tax cuts to promote growth.  It is a little bit like when Adolf Hitler ordered the offensive on the western front in the Ardene forest in Belgium, in 1944 (Battle of the Bulge). Despite not having the necessary fuel to keep his army moving forward for a sustained period, he went ahead with it anyway.  In the end, the losses did not justify the gains, and the Whermarcht was pushed back.  Tax cuts, even if we were to assume that my analysis is wrong and it would indeed lead to economic growth in the US and thus worldwide, given the size of the US economy would not keep the good times rolling for long. How long before we would reach another point where demand will outstrip oil supplies and we would hit the wall as hard, or even harder than we did in 2008?  Total liquid fuel supplies worldwide have been increasing at a pace of .5 mb/d per year since 2005, when conventional oil plateaued.  To get back to the economic expansion we witnessed until then, we would need for that average increase to at least double or about 1 mb/d per year.  So the best republicans can hope to see courtesy of their tax cuts is a period of growth of a few years, and hopefully they will be out of office, once it all hits the wall again as it did in 2008.  Then, they can point the finger at the other guys and point out that when they were in office the economy was growing, so naturally the new guys must have messed up, so people should elect them again.  Meanwhile neither side will effectively address the underlying issue of resource constraints on growth (I addressed this issue in more detail in this article  Link), and thus we will dig ourselves deeper and deeper into a hole and squander our remaining vibrancy on a futile attempt at getting back to the pre 2005 economy.


[ii] The multiplier numbers I used are purely fictional, and I should also point out that while economists have been attempting to measure multiplier effects of various types of infusions of money into the economy, there is no standard multiplier number that can be applied, because there is never agreement on what the number is.  As variables change, so does the multiplier.  The main variable is the Marginal Propensity to Consume (MPC).
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