Thursday, September 20, 2012

Tax Cuts Used to Work...But Now.???

Tax Cuts (and Deficit Spending) Used to Work

The US economy boomed after the Reagan tax cuts and after a big recession that "tamed" inflation.  Reagan and Thatcher changed the course of Anglo economies for decades--given that the UK and US were on or almost on life support in the late 1970s.  (The UK received an IMF bailout in 1976).

Of course, marginal tax rates during the Carter administration was as high as 70% for individuals and 48% for corporations.   But also remember that there were a myriad of deductions to drastically reduce the "effective" tax rate.    In fact, the total income tax take by the Federal Government has been remarkably stable at about 14% regardless of tax rates or president or party for over 30+ years.  The difference between marginal and effective provides enough confusion for both sides to "demagogue" the tax issue.

Since the wealthiest people have always payed the lion's share of taxes, any change in top marginal rates helps them the most in dollar terms.  Note that the top 1% used to pay as much as 29 to 33% now pay about 24%, but as you can see below all of the income categories saw significant tax reductions since 1980.

Here's the raw data.  The original graph is here.

All of the Republican tax cuts increased deficit spending initally then revenues rapidly accelerated within a few years and reached new record collections.  This worked very well during the JFK and Reagan years, but only worked "ok" after the (Dot-com) recession inherited by Geo.W. Bush presidency.

With national debt levels rising, it appears that there is an decreasing effect of debt spending, ie., less "bang" for the debt "buck".  Rogoff and Reinhart have documented that the level of debt matters and over about 90% of GDP, growth slows by at least 1%.  That may not sound much, but if normal growth level is 3%, then 2% is significantly lower.

Other information confirms this.  Take a look at the graph below which shows the declining efficacy of debt creation to create GDP growth.   We're definitely losing the Keynesian "bang for the buck."  The graph is now above zero and at about $0.30 but this latest number might very well be a near term peak value.

The major implication now is that tax cuts (with the subsequent increase in deficits) may not work well this time.  There may be no panacea for this downturn.  It's possible that cutting government spending and reducing the deficit (so-called austerity) may not have much of a lasting effect especially if offset by even larger tax reductions.

I argue that for the following policy steps:  1) more domestic energy, 2) repatriate asian jobs back to America by creating tax incentives for businesses to repatriate capital and jobs, 3) flat or flatter income tax rates, 4) utilize our new-found natural gas reserves for transportation fuel and displace oil imports, 5)  big government spending cuts but bigger tax cuts to offset them.

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