In my quest to rationalise my desire for the state to control every aspect of people’s lives, I have formulated and collected together a few reasons that tax increases may actually be expansionary. This is an ex post justification, in light of apparent empirical evidence that they don’t have the negative effects so often attributed to them.
To understand why tax increases might be expansionary, we don’t have to abandon the logic of ‘econ101′ entirely – that is, if you reduce the reward somebody gets for doing something, or increase its cost, they will do it less. However, a couple of real world mechanics – which are omitted from economic thinking – can use this logic to conclude that tax increases could potentially be expansionary:
(1) Many productive activities are tax-deductible. Profits that are reinvested are not taxed; similarly, corporation tax is deducted from the cost of employing someone. So the higher these taxes, the greater the incentive to engage in these activities. There is potentially a point where the negative impact of the tax outweighs these positive effects, but we don’t appear to be anywhere near it.
(2) Economic rents are highly pervasive, particularly at the top. Taxing this activity discourages it and hence encourages productive activity. According to Michael Hudson, this was the intent of the original income tax. A clear example of this effect is the Land Value Tax – if landlords are charged for sitting on their land doing nothing, it encourages them to make some money, or sell the land to someone who does.
There are also some other mechanisms that suggest tax increases might be expansionary, some of which I have explored in earlier posts:
(3) The fact that the income effect is stronger than the substitution effect can mean that higher income tax makes people produce more; that is, when faced with higher taxes, people will have to work longer hours to recoup their post-tax income. This adds to gross national product.
(4) Cutting taxes at the top can simply inflate the price of positional luxury goods and hence do nothing to help real production; if that money were redistributed, it would be spent on ‘normal’ goods and hence have more impact on growth.
(5) Governments can spend your money better than you, so higher taxes and spending will increase the productive potential of the economy.
(6) Another interesting proposition from James Kroeger: tax and spend means more money is spent.
The crux of the argument is that it is reasonable to say the population as a whole has a Marginal Propensity to Consume (MPC) of less than one – they save some of their income. The government, on the other hand, has an MPC of at least one. Hence, should money be taxed and spent, there is a high possibility that this increases national income.
Kroeger also notes that people often confuse the expansionary effects of borrowing with those of tax cuts. To fund tax cuts, the government often has to borrow to sustain current levels of spending. However, in this case it is the borrowing that is expansionary, rather than the tax cuts. To truly see the effects of reducing taxes, we’d have to reduce taxes and spending by the same amount.
Another point worth noting is that, whilst taxes might have a deadweight loss in the area to which they are applied, the money that would have been spent does not disappear – it can go into other areas. In other words: if you tax cars then people might spend less on cars, but they’ll also have more to spend elsewhere. So taxes are more likely to change the composition of national income than the total.
Some of these effects are stronger than others; maybe some are negligible or based on faulty reasoning. But the overall combination of conflicting effects makes the story far less clear cut than the basic ‘econ101′ approach to taxes would have you believe.