Monday, January 05, 2009

Tax Cuts Should Boost Private Savings

It is now reported that about 40% of the expected Obama fiscal stimulus plan will come in the form of tax cuts. Or at least, what is labeled as tax cuts, as some of the tax cuts he proposed during the campaign weren't really tax cuts, they were more like government transfer payments.

Anyway, if (with emphasis on "if") we are to have some kind of Keynesian "stimulus", then tax cuts are preferable to active efforts to achieve monetary inflation and spending increases. That is because first of all, tax cuts (at least genuine ones) improve incentives for productive efforts. And secondly, because they leave the decision of ultimate spending to private households, in sharp contrast to direct government spending (though this is also true of government transfer payments).

I now see that Harvard economics professor Ed Glaeser also favors tax cuts as the preferred method of stimulus. However, he appears to favor targeted tax cuts just for low income earners, because they are more willing to spend it, similar to the plan Obama presented during the campaign.

There are two problems with this: first of all, if you phase out tax cuts with rising income, you increase the marginal rate of taxation and so reduce incentives for productive efforts. And secondly, higher private savings is not a bad thing. Indeed, a key problem in the U.S. economy is that household savings remain too low and household debt remains too high. By boosting private savings and enabling a reduction in the level of private debt, firms will feel safer that households will be able and willing to buy their products in the future and so increase investments.

The large deficits that this plan presupposse will of course counteract this effect, as the fear of future tax increases will limit investment spending, which is why it is not a cure per se. But at least the negative effects of the deficit will be counteracted by the positive higher private savings. If the deficit is used for spending by contrast, the effect will be lower long term investment and so lower long term growth.

So, while "socializing" debt by increasing private savings through higher government deficits may not solve the problems, at least it won't aggravate them. If by contrast the deficit is used for spending, the problem with a too low savings rate will only be aggravated.

5 Comments:

Anonymous pinus said...

"first of all, if you phase out tax cuts with rising income, you increase the marginal rate of taxation"

This is not correct, unless you have in mind a compound system where taxes paid in the first stage serve as deductibles in the second stage (and then these increases can be easily avoided by suitably structuring the cuts, while still keeping the phasing-out property of the cuts).

(This is not a stance on whether such a structure of tax cuts is favorable or not.)

6:41 AM  
Blogger stefankarlsson said...

Pinus, what I have in mind is not a system where all people get a $1000 in tax cut. What I have in mind is the proposed system where people under $50 K or $100 get a $1000, but people earning over $100K or $150K get zero in tax cut. This will mean that in the range of $50K-$100K or $100K-$150K, the marginal rate of taxation will increase by 2 percentage points. I don't see how you could dispute that.

2:24 PM  
Anonymous Anonymous said...

Keynesians will go mad about the tax cuts. That will enable the recipients to save the money or pay off their loans. In both cases banks will place the money as reserves at the central bank.

Keynesians look for methods where at least some spending is guaranteed. That is the only way for inflation and negative interest rate to happen.

Johan

10:35 PM  
Anonymous pinus said...

Stefan, you are right with your example. I was thinking along the lines of decreasing the tax rates in the bottom tax brackets for everybody, which would get you around the problem of increasing the marginal taxes. Nevertheless, a strict interpretation of what is claimed in the linked article is of course in line with what you said.

5:48 PM  
Anonymous Anonymous said...

> What I have in mind is the
>proposed system where people
>under $50 K or $100 get a $1000,
>but people earning over $100K or
>$150K get zero in tax cut.

There's also a precedent for this: last year's "stimulus" package...

Anyone earning over $75,000 got shafted.

3:07 AM  

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