Friday, May 19, 2006

Tax cut myths and nonsense

Tax cuts stimulate the economy and help us support the 'Mommy-state'

by StFerdIII

Tax cut myths. They abound don’t they. Cut taxes and the poor will die on the streets. Cut taxes and the old people will be slurping dog food, unable to inject their bodies with the normally prescribed 754 different drugs they need. Cut taxes and education will stop. Cut taxes and socialized health ‘care’ will collapse. Cut taxes and murder rates will go up. Cut taxes and all infrastructures will collapse. Cut taxes and some pencil head who works for the government might lose his job. Geez no wonder populist politicians greasing their hands to buy votes reject tax cuts. Even so-called conservatives act more like drunken socialists than someone from the school of Churchill, Reagan or Edmund Burke. Yet the tax cut myths are pretty easy to destroy so let’s do so.

There are 4 or 5 basic tax cut myths and they all revolve around misconceptions on how the economy really works. Yet they are powerful myths as disturbed and evil as the global-warming earth goddess cult that passes for science, and these fantasies allow government to grow and people to lose more money to ever expanding social programs of nonsense. Myth #1 used as a favorite by the New York Times and the CBC and their left wing media friends is that tax cuts magically force up interest rates. The theory is that tax cuts will result in deficits and deficits force rates up. Actually tax cuts have nothing to do with deficits – high spending does. If you cut taxes you should cut spending. But even if you don’t reduce spending, the increase in deficits has no impact on interest rates. One reason is that the US has $30 Trillion in capital. The world has $100 trillion. A US deficit for example of $500 Billion, has no impact on capital markets and interest rates.

A quick look at monetary history shows that deficits and rates are unrelated. From 1982-1992 the US ran 10 consecutive years of deficits, and massively increased its national debt yet 30-year mortgage rates fell from 18% to 8%. Between 1992 and 2000, deficits disappeared and surpluses took their place. Mortgage rates did not move. In late 2000, despite the largest annual surplus in U.S. history, 30-year mortgage rates were still 8%, the same level as 1992. Since 2001 thanks to a Clinton inspired recession, terrorist attacks, war, and tax cuts, the federal budget is back in deficit again. But 30-year mortgage rates fell to 45-year lows of just over 5%. For the past 21 years, deficits and interest rates have moved in opposite directions. As deficits have grown, interest rates have fallen. So much for that myth.

Another objection to tax cuts is this: we need to put money directly into people’s pockets and this is preferred to ‘indirect’ tax rate cuts. This of course is real gibberish. If stimulating the economy worked on such a premise, then just printing money and handing to people would be the obvious policy choice. But economies don’t work this way. Borrowing and then spending money to take from one group and give to another, does not encourage productive economic activity – in fact it destroys economic value. The only exception to this is if a government for some reason is cash rich and has no debt – only Alberta perhaps can qualify in North America as such a jurisdiction. For the rest a tax rebate must come from somewhere. If the government borrowed money to pay the rebate, then taxes would eventually be raised to pay it back. As well most people will use any rebates to pay off debt not spend on new purchases, so the effect of a tax rebate is extremely limited and short term. Tax cuts if made permanent however, alter behavior in the long term and stimulate the economy and job growth far more than money rebates. So much for that myth.

Another hoary tax cut myth is that the tax cut must only be judged by its size. If it is not large then why bother? The bigger the tax cut bang the better so the myth goes. Certainly I am all for massive tax cuts but it is more vital to alter behavior. If good behavior is rewarded, this will stimulate economic growth, investments and productivity. Example: in 1997, the Clinton capital gains tax rate reduction was estimated to ‘cost’ just $3.3 billion over five years. By any measure of absolute size, this was small. But its impact was huge. Venture capital investment soared by 400 percent and the stock market expanded at an annual average of over 20% for five consecutive years. This led to massive investments in technology and the corresponding stock market boom. So much for the size myth.

But the socialists will persist with yet another tax cut myth – the hard to define ‘tax bracket creep’. If inflation rises as it did in the 1970s and 80s then wages will artificially go up pushing people into higher tax brackets. This is an effective tax increase. Some governments in the 1980s then decided to index tax ‘brackets’ or rates to inflation. Problem solved right? Well no. Tax ‘brackets’ need to be indexed for real income gains not just inflation. If for instance the tax brackets were never changed, over the next century, real income gains thanks to productivity increases, would force every single Canadian and American into the top tax bracket, even those with the lowest income. In other words as society becomes more prosperous and incomes rise tax rates will effectively go up. A good deal? No way. The remedy ? Well of course – cut the tax rates and index tax brackets to rising income levels. In other words we need tax cuts to ensure that rising incomes are not stolen by government. So much for that myth.

Why do tax cuts work? They work because they increase the incentives for new investment, not by stimulating demand. In the early 1980s, despite large tax cuts, consumers were not banging down the doors of local retailers for fax machines, cell phones, PCs, or broadband Internet connections. It was only after some very smart entrepreneurs decided to risk a great deal of money, time and talent developing these new goods and services that they became so ubiquitous. By cutting taxes on income and capital gains in the early 1980s, Ronald Reagan encouraged these entrepreneurs to take the risks necessary to develop these new technologies. To paraphrase Say's Law: Supply created its own demand. Incentives are what matter, not pocket money. In 1997 Clinton cut the capital gains tax rate from 28% to 20%. This meant that the after-tax return from a $100 capital gain increased from $72 to $80—an 11% increase. This 11% increase in incentives led to the late 1990s boom in stock prices, venture capital investment and innovation.

For the same capital gain, the 2003 Bush tax cut will increase after-tax returns by 6.6% (from $80 to $85) and for dividends by more than 30% (from $62 to $85). These changes will reduce the cost of capital, encourage more investment and savings, and cause more companies to pay dividends. The end result will be an increase in economic growth, rising stock prices and a rebound in venture capital investment. For the socialists note this – thanks to tax cuts US government revenues are up 15 % per annum as higher growth rates stimulate more revenues; profits and lower rates alter behavior to claim incomes instead of hiding profits from the tax man. Tax cuts actually result in more government revenue. If governments are smart enough to pay off debt and downsize spending is entirely a different matter.

The message is clear – to solve poverty, produce wealth for social services and maintain a strong military all the while paying off the debt and putting monies into future reserve funds – cut taxes and non-essential spending. Don’t worry grandma won’t be eating dog food anytime soon.