Taxes or spending ?

Whether the 1.4 trillion dollar US budget deficit should be balanced by increasing taxes or by decreasing spending is a question that is likely to be at the forefront of public policy discussions for quite some time to come. Republican intransigence will make it difficult to raise taxes. As for spending, the Republicans had control of the White House and of the Congress during the George W. Bush years. Yet even they could not cut spending to the level that could have balanced the budget, thereby proving that most of the spending is needed direly. The extra spending due to the wars started in the wake of the 2001 attacks is another matter. There can be different opinions about how necessary they were. But the build-up of the debt due partly to these wars has happened, and will create increasing strains on public finance in the future.

As for increasing taxes, there is what appears to be a conspiracy of inaction on this question. Any kind of excuse is brought forth about this. If there is a mild recession or a deep recession, then many pundits argue that increasing taxes is not a good idea. The justifications are often unclear. The usual argument goes like this. If, say, corporate taxes are raised, companies will invest less since their future profits will be taxed at a higher rate. This argument has serious problems. In a capitalistic economy, where most companies have strong competitors for most of their products, innovating and investing are necessary for competition. That my future profits will be taxed at a higher rate does not mean that I will stop innovating and investing and give my competitor a free run. Unless there is collusion between companies, a large-scale investment freeze due to higher tax rates is difficult to understand in a free market competitive environment. A large-scale investment freeze due to depressed economic sentiments makes more sense than one due to tax rate increase. When the public debt is not very burdensome, this kind of efficiency arguments can carry force. However, during times of high debt levels, this conventional wisdom may need to be challenged and subjected to scrutiny. Also, corporate tax revenues do not constitute that large a percentage of the total revenue. The historical data shows an increase of 100-200 billion per year in corporate tax receipts from lower corporate tax rates. However, this is small compared to the deficits.

Right now, companies are holding on to large amounts of cash. Whether they are doing it due to uncertainty about tax rate policy, or whether they are doing it due to a general environment of negative economic sentiments and depressed demands, is not clear. Once again, in a competitive environment, and in a world where new products need to be introduced almost as a matter of routine, the tax-policy component of this lack of investment enthusiasm is difficult to make sense of since any particular company and its competitor will face the same tax rates.

Also, if I am an owner of stocks, I and everybody else who has expendable money to buy stocks will face the same tax rates. Also, as a stock owner, to what extent will I forego the opportunity to buy additional stocks in a company that has an excellent innovation that it intends to incorporate in a new product ? Also, if I have money to buy stocks, and if the capital gains taxes are raised, will I buy more or less stocks ? It is a complicated question, and the response to higher capital gains taxes can be to buy more stocks or to buy less stocks depending on the circumstances of the individual.

How about income taxes ? What happens when income taxes on high income earners are decreased by a lot ? This is most likely to lead to a re-allocation of income towards luxury good compared to basic goods. If high income earners tend to save a larger fraction of their retained earnings, then it can also lead to an increase in savings available for investment. This can spur growth and create new jobs. However, it has to be correctly quantified lest its effect is exaggerated. Also, the question arises, why did this factor not lead to high enough revenue increases during the George W. Bush years to offset the effect of lower tax rates on the revenue ? In fact, if one compares the trend of income tax receipts as a percentage of GDP through the 1990s and the first decade of this century, it is quite clear that, depending on which year of the Clinton period is compared with which year of the George W. Bush period, income tax receipts as a percentage of GDP remained either the same or decreased from the 1990s to the middle of the last decade. If one compares the middle of the Clinton years with the middle of the George W. Bush years, which were non-recessionary periods, the income tax receipts were almost the same as a percentage of GDP. If one compares the highest income tax receipts of the Clinton years with the highest income tax receipts of the George W. Bush years, then they decreased from about 10% of GDP to about 8% of GDP. Also, GDP growth was no better during the George W. Bush years than during the Clinton years.

Even when the economy is out of a recession, there is paranoia about increasing taxes. Again, many of the same arguments are given, often without any cogent logic to them. High tax rates have existed in the past, and have had a positive effect on public finances. This is consistent with some of the arguments outlined above about competing companies, about the response of investing entities to increases in corporate or capital gain taxes and about the fact that GDP growth rates do not respond to tax decreases so drastically as to offset the effect of lower income tax rates.

What about a situation that involves a combination of deep recession by historical standards and also an alarming level of public debt, like now ? Even here, the paranoia about higher taxes may well need to be challenged. Actual historical effects of tax rates on GDP growth and on investor confidence need to be quantified. The bigger evil has to be identified. Excessively alarmist sentiments about higher tax rates can prove fatal. It may be better to have lower GDP growth rates if the reward is the avoidance of crisis-like situations like a debt default in the future. What about unemployment ? Is it better to risk lower growth and higher unemployment to make the system solvent now, or is it better to wait for the economy to recover ? The question is a difficult one, and I have not come across deep quantitative studies that address this trade-off. The instinct of this writer is that it is better to restore some of the higher income tax rates on the super-wealthy. The economy is growing according to official statistics even though unemployment numbers have stayed at >9.5% for more than a year. This is a better time to judiciously fix the revenue side than to wait for a crisis like a sovereign debt crisis. If a debt default occurs, all the trade-offs will become more difficult. Also, the reality is not encompassed by the efficiency aspect alone, as is often made out to be the case in debates. There is a fairness aspect also that tends to get overlooked. Alarmist sentiments can be justified only so much and not more. Judiciously identifying areas where taxes can be increased without affecting growth very negatively will be one of the tests of a mature administration and a mature Congress. Employment generation, growth and identifying ways to increase revenue are things that need to be addressed simultaneously, and not in sequence.

European countries typically tend to have high income tax rates and high payroll tax rates. This may be a good model to adopt in America as well. With such a distribution of tax rates, a lot of the problems facing the American economy now could have been avoided. The corporate profit plough-back component of investment is not affected directly by these tax rates. The stock ownership component, as argued above, can move in either direction, in response to higher income taxes. Whether such a judicious approach to revenue restoration will be followed may well determine if a bigger future crisis can be averted in America.