Friday, August 29, 2008

More on tax cuts (pun intended)

Economist Jason Furman (real economist, not self-proclaimed, he has a Ph.D. in economics from Harvard and served as Special Assistant to the President for Economic Policy in the Clinton Administration.) notes that the Congressional Budget Office, the Joint Committee on Taxation (JCT), and academic researchers have found that tax cuts that are financed by borrowing, hurt the economy over the long run; please see here for more.

So in other words, tax cuts that are financed by just increasing the deficit mean more national borrowing, which lowers net national savings, and thus investment. And as any family knows, the less you save and invest, the poorer you are over the long run. Thus, the serious unbiased studies that have been done show that a dollar in tax cuts ends up costing more than a dollar over the long run, not less, if it's financed by government borrowing.

What if it's financed by cutting government programs? Well, as I wrote in my last post, many of those government programs have extremely high social returns, like alternative energy, infrastructure, education, basic scientific and medical research, etc., and are things that the free market will grossly underprovide (provide at a level far less than that which yields maximum growth and welfare) due to market imperfections that are well established and proven in economics (real, scientific academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Tax cuts, on the other hand, it has been found, tend to eventually be spent, by and large, on short term consumption items of little or no productive or investment value. If you cut your spending on productive infrastructure, alternative energy, education, etc. to give big tax cuts to Paris Hilton and friends so they can buy more million dollar Ferraris, and have more nights in $50,000 hotel rooms, you end up far poorer as a nation over the long run, not richer. These things have little or no productive or investment value. They're consumption, not investment. A dollar in tax cuts ends up costing you far more than a dollar over the long run, not less, as the Republican machine would like us to believe.

What if you cut wasteful government spending? Well, that should be cut no matter what, with or without tax cuts, but history has shown that cutting of waste actually decreases -- and greatly -- when we have Republican administrations and these giant tax cuts tilted massively towards the rich. There are several reasons for this. First, Republicans dislike and disrespect government, so they put little or no effort into learning how to run it well. Second, cronyism is ingrained in the party (update: please see here.), and third, there is a culture of corruption, and this is largely necessary if Republicans are to maintain power. With positions that are so harmful to the vast majority of Americans, they need to please rich corporate and individual donors in order to raise the money necessary for large scale advertising and propaganda to mislead and distract.

So the tax cuts end up being financed by government borrowing and cutting of government programs that have high or extremely high returns. You don't get richer by "saving" money by cutting your investment in your education, your mutual fund, and your government bonds, so you can spend it on a five star vacation or a new SUV.

Finally, what about Republican claims that tax cuts will make people work more hours because it increases their pay per hour? First, people today, by and large, work so hard, and spend so little time with their families by historical standards and compared to people in other countries, that it's not at all clear that this is desirable, and it's not even physically possible to work many more hours at this point. In addition, there is a point where production is decreased from more hours, because eventually it really hurts the quality of work. People become tired and burnt out. Competence and creativity are hurt. But aside from any of this, it has been shown in economics that in fact there is little long term relationship between tax rates and work hours. For most of the 20th century real wages per hour went up greatly at the same time that hours worked dropped. There's little long term effect, and what effect there is can easily go in the other direction. Cutting taxes can decrease work hours. A key reason is the long ago established and accepted in economics, income and substitution effects, which you can find in any university microeconomics text.

The idea is this: If you raise someone's wage from $8/hour to $12, they may go from 40 hours/week to 45, because they get $4 more for giving up an hour; that's the substitution effect. But if you raise their wage from $8/hour to $1 million/hour, they will probably work like 40 hours per year! And then spend the rest of the year enjoying all of that money. That's the income effect. When you raise someone's wage per hour, they don't have to work as many hours to live in a way that they consider well. Empirically, it appears that with taxes at about their current level, the income effect becomes greater at about the middle class level, and then we get what's called a backward bend to the labor supply curve. Cornell economist Robert Frank has a nice brief New York Times Economics Scene article explaining all of this, "In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up".