The Tax Cut Fallacy, or Why "Trickle Down" Doesn't

I hear people talking in the hall.  Unfortunately, sometimes I hear them and I can't just shut my door (or my ears).  Recently, I heard a couple of people talk about how our economy is in trouble, and we need to "cut government and cut taxes, so people can afford to hire help".  That got me thinking - again - about how backward the tax cut cheerleaders have it.

Since I worked for a number of years in manufacturing, I tend to look at business from that perspective, but the principles are the same for other industries as well.

Wealthy people are "Job Creators" in the same way that your local TV weatherman is a "Rain Maker".  Jobs are created in response to demand - people want your product or service, so you need to add staff to fill that demand.  Think about it:  what happens if you add production capacity (more people) without effecting demand?  Clearly, you increase the supply, leading to a glut on the market, and REDUCING prices.  Revenue goes down, while expenses are increased due to higher labor and material costs incurred by making product you don't need.  

Fortunately, rich people aren't that stupid!  When they get tax cuts, they have more money.  They don't, from my experience, feel any great need to rush out to spend it.  Certainly, they may decide to blow it on something they've wanted, but for the most part, they already have everything they need (and most of what they want).  A windfall is probably going to be invested - the more well off someone is, the more likely they'll have a financial plan.

Contrast that with what happens when someone of low or moderate income gets a raise.  They are very likely to spend the extra income on living expenses.  A small amount of money may just go towards paying off bills or credit cards, while a big bonus may mean a new TV, Car, or Home.  Since they have some needs (or wants) that are not satisfied, they will be much more likely to spend the money immediately, rather than invest it.

Now, don't get the idea that I think the country would be better off if everyone spent their whole paycheck every week - far from it!  We're talking about the best way to heat up a sluggish economy here, and the best way to do that is to pump up demand and create jobs.  Swimming lessons are important if you want to keep your kids safe from drowning, but if they fall in the lake, throw them a life preserver!  Long-term investment is important, not only to the financial health of the individual, but also to the economic security of the country as a whole, but nobody can worry about their retirement income if they can't afford to put bread on the table today.

There are cases where tax policy can make an impact.  Some states - including Nebraska - have from time to time introduced tax incentives to businesses giving credits for opening new facilities, expanding existing ones, or creating a certain number or percentage of new jobs.  While these programs may lure businesses to expand in that state or city, they don't effect the underlying demand.  In essence, you're recruiting the business to your state by taking it away from another - that's great for one state, but does nothing for the national picture.  It also seems strange for all the "Free Market" types to advocate these policies.

So, if we accept the premise that the best way to ramp up the economy is to get more buying power into the hands of the ones most likely to actually buy something, what's wrong with using tax cuts to do it?  Nothing, really, except it's an inefficient and sometimes unfair way to do it.  The biggest problem is that lower income people don't pay much in income taxes (and income taxes are the primary focus, at least as far as the federal government goes), so the tax cuts just don't do much for the economy.  My mother, who will occasionally complain about her tax bill, pays only a few hundred dollars per year in income taxes.  A 10% reduction would have absolutely NO impact on her lifestyle or the economy.

How about moderate income folks?  Tax rates are a little higher, so the effect is much more significant - there is a little more money to spend, and middle-class folk would have plenty to spend it on.  Of course, a lot of those people would use the cash to try to get caught up on bills, or to put a little away for a rainy day - both fine uses of money, but they may not have the immediate impact on the economy we're looking for.

Much of the problem with these schemes is that in order to have a significant boosting effect, there has to be enough money involved.  Tax cuts, for most of us, means a few more dollars in our paycheck each week - that may help, but it isn't the big shot in the arm that a really sick economy may need.  Cutting taxes on the high earners equals a lot of money, but, as we've already discussed, it won't do much for the economy.

The other problem with using tax cuts as economic stimulus is that the timing is wrong.  They're implemented too late, and continue for too long.  The Bush Tax Cuts were enacted mainly because we had a surplus from the Clinton years.  They've been in effect for the better part of a decade, whether they were necessary to stimulate the economy or not. It's very difficult politically to increase ANY taxes, so they just keep getting extended, even in the absence of evidence that they are doing any good.  Maybe our taxes are too high, maybe they're too low - my point is, these cuts are not being extended for economic stimulus.  These tax cuts were started - and have been extended - purely for political purposes.

Tax credits can be an effective way to improve a segment of the economy.  The recent tax credit for first-time home buyers certainly generated a brief flurry of activity in the housing market.  Unfortunately, the effect was temporary, and did little to solve the longer-term problem (in fact, the market was even MORE depressed for a period of time after the credits stopped).  I remember a number of potential buyers telling me they would "wait to buy until there's another credit".   Therein lies the issue I see with temporary tax credits - they stimulate the heck out of people while they're going on, but usually depress the same segment of the economy when they're discontinued.

If you're going to try to stimulate the economy with tax reductions, something like the payroll tax holiday makes sense:  Low and middle-income taxpayers get a temporary, significant respite from withholding.  They get extra money in every pay check, and everybody knows this is just for a limited period. Tax credits, as well as reductions, are fine if they can be used as temporary measures.  To dig out of the current hole, these tactics are inadequate to get the job done.

There are no quick solutions to our problems, but we need to get started on long-term plans.  We should invest in education - not just primary school, but post-secondary education, including engineering, business, and the sciences.  We should consider public funding for at least some schooling past high school - be it an associates degree, a technical degree, or even a bachelors degree.   It's sad that so many public school systems are struggling to make ends meet.  Failing to fund public schools is like saving money by not changing the oil in your car - it's going to cost you a lot more in the long run.  Our manufacturing facilities - or any of our industries - can not complete if our work force is under-educated or illiterate.  I'd like to see us invest in significant projects to repair or improve some of our deteriorating infrastructure.  In addition to providing a much-needed boost to the construction industry, it would solve a problem that's going to bite us sooner or later - many of our roads and bridges will need extensive repairs, and local and state governments don't have the money to make it happen. Instead of denying the facts regarding environmental concerns, we need to address those concerns and lead the world in developing solutions to reduce pollution and develop new energy sources.  In short, we need a Progressive agenda - something that counters the old "conservative" thinking.

The national debt is certainly a long-term problem - I agree that we need to take steps to bring it under control.  We just don't need to destroy our economy to fix it (in fact, drastic spending cuts won't fix it at all, since we'll plunge ourselves into a recession).  As our economy improves, we'll need to get the debt under control.  At that point, I'd like to see us begin to reduce military spending to a more reasonable part of our total budget (of course, we can't cut that too quickly, either, or we'll send our economy into a tailspin).  Amazingly, virtually no politician has been willing to put military spending on the table when they're talking about balancing the budget.

I don't like paying taxes any more than the next person, and I love it when my tax bill is reduced - I just don't see taxes as evil in every case.  Too often, taxes and the government are the bogeyman for everything that's wrong with this country, and it's just not true.  A progressive tax system is not only fair, it is best for the overall health of our economy.  Our economic problems have grown over the past four decades, and it's going to take some time to implement solutions.  As much as we'd all like to believe it, we need to understand that tax cuts don't fix everything.