May 4, 2017

People are saying….

Do tax cuts stimulate the economy?  The idea that tax cuts stimulate the economy is the basic assumption behind President Trump’s budget proposal.  I asked two economics professors at Stevenson if this were true.  As it turns out, it is not a simple question.  Here are their answers:

Tax cuts do stimulate the economy because households will have more money to spend. However, if tax cuts displace worthy government spending such as needed infrastructure enhancements, the net effect will be contractionary as many households, particular the wealthier ones, will save and not spend a large portion of their tax cut. By contrast, infrastructure spending provides a direct injection to the economy and is more potent and would enhance productivity as well. Finally, tax cuts that are not offset by budget cuts run the risk of ballooning budget deficits that will end up stimulating more inflation rather than real growth in the economy.  ~Timothy R. Holland


Do tax cuts stimulate the economy? It depends. It depends on which taxes are being cut, and on the state of the economy.

In general, the idea of stimulating the economy via a tax cut, the so called supply side economics, advances the idea that providing additional money to individuals and corporations will be channeled into stimulating supply and demand. However, this theory, for the most part, turned out to be false empirically.

Let’s take Trump’s latest proposal for corporate tax cuts: cutting the corporate tax rate will only pad the corporations’ wealth but will not create new jobs, nor will it stimulate the economy. They will create more jobs if and only if there is an increase in DEMAND for the goods and services they provide. Currently our economy is operating at full employment, yet people’s real income has not been growing. Therefore, there is no indication that demand will increase in the near future. Furthermore, with this massive tax cut, our national debt and yearly deficits will grow more rapidly. As a consequence, the rate of borrowing will increase, and that will cause the interest rate to rise. An increase in the interest will actually choke growth as investment will drop. The only time when a decrease in the tax rate will help stimulate the economy is when the economy is in a recession and the tax cut is aimed at people at the 90 percentile of income. That in turn will help stimulate demand which will ultimately increase growth.  ~ Ora Freedman