Sorry, but tax cuts don't stimulate the economy

Republicans have predicted that the just passed GOP tax cut bill will work like gangbusters on the economy.  And they are right, but for the wrong reason.  Tax cuts don’t stimulate the economy, but government deficits do, and the GOP tax cut bill promises to increase the federal deficit by around $1.1 trillion.

The same thing happened with the Reagan tax cuts in the 1980s.  People forget the bad economy during the first part of the Reagan administration and only remember the strong economy after the 1981 tax cuts were passed without any corresponding spending cuts.  The cuts were supposed to “pay for themselves” but when they didn’t, the deficit soared.  Reagan and the Congress then passed tax increases to control the deficit (no one remembers “Ronald Reagan, tax raiser”), but the initial stimulus created the “Reagan miracle” of an improved economy.

Why doesn’t a tax cut stimulate the economy?  Don’t tax cuts put more money in people’s wallets?  Let’s look at the impact of a state tax cut on a state economy, one where the state has to maintain a balanced budget since states can’t pay for tax cuts by printing money.  Every dollar of tax cuts must be accompanied by a dollar of lower state spending, whether it be on education, social services, or the proverbial waste, fraud and abuse.  So the economy is stimulated by greater private spending, but retarded by less public spending.  The economy can’t tell the difference between a dollar spent by the state or a dollar spent by a private citizen; the net effects cancel out.

But wait, there’s more (as the infomercials say)!  Under standard economic theory, people don’t spend every cent of every dollar they earn.  Most people, especially those who are not in poverty, save some of their income for the proverbial rainy day.  Let’s assume that the typical person saves 5% of their income and puts it under their mattress, or in a nice savings account.  That means that a dollar tax cut only produces 95 cents of actual stimulus.

The government, of course, does not save for a rainy day (at least, not usually; some states, like California, have a “rainy day fund” to help the state during economic downturns. But these funds are usually a small percentage of the budget and are quickly exhausted during an economic downturn).  So when a state cuts taxes, it forgoes spending 100 pennies in order to give a dollar to a taxpayer who will then spend 95 pennies.  Thus state tax cuts do not stimulate the economy, they actually make it less robust.

Federal tax cuts can stimulate the economy, but only when they are accompanied by increased deficits.  It is the deficit that improves the economy, not the tax cut.  Republicans claim they hate the federal deficit, but they love cutting taxes that makes the deficit bigger.

There is one possible rebuttal to this analysis, that tax cuts do increase savings but savings are used by banks to lend capital, and capital is used to build businesses up.  That is factually true, but the mechanism by which increased investment leads to economic growth is not well understood, and the benefit should be delayed by several years.  Also, increasing the deficit by printing money will affect both inflation and interest rates in ways that difficult to anticipate.  That spending (either private of governmental) stimulates the economy is straightforward and incontrovertible.

So the GOP tax bill might stimulate the economy in the short run, but eventually the deficit-hawks are going to start demanding spending cuts (or tax increases) to pay for them and when that happens the economy will dip into another recession.  Yes, Republicans may think that taking food stamps away from hungry children is a lot of fun, but the money in that social program (and others) goes to farmers who support their families by buying consumer goods, and it then is spent by providers of consumer goods on their families, and so on and so on ad infinitem.

The next stage in this pantomime is that after a slight boom the economy will start to lag, Republicans will say it is the deficit’s fault and urge spending cuts in social programs, Democrats will counter with proposals to pare back on the tax cuts, Republicans will accuse the Democrats of wanting to raise taxes yet again, and meanwhile the deficit will grow. 

The irony is that the Republicans are right to worry about the deficit, but will attempt to benefit politically from making the problem worse.  Will voters be smart enough to realize this?  That is what the 2018 midterm elections will show.