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Tax Cuts Versus Government Growth

June 2, 2003

On May 28 President Bush signed into law a $350 billion package of tax cuts and state aid. Millions of Americans will begin to see the effect of the package within weeks, in the form of bigger paychecks. Also, in July some 25 million families will receive up to $400 per child in tax credits.

With more money in their pockets, the President believes Americans will be able to spend more and this will speed up economic recovery. According to President Bush,

"By ensuring that Americans have more to spend, to save and to invest, this legislation is adding fuel to an economic recovery. We have taken aggressive action to strengthen the foundation of our economy so that every American who wants to work will be able to find a job." 

The belief that putting more money in consumers' pockets will revive the economy is based on the popular view that a given dollar increase in consumer spending will lift economic activity in terms of gross domestic product (GDP) by a multiple of the increase in consumer expenditure. An example will illustrate the magic of this multiplier.

Let us assume that on average individuals spend 90 cents and save 10 cents of each additional dollar they receive. Thus if consumers raise their spending by $100 million, this will boost retailers' revenues by this amount. Retailers in turn will spend 90% of their new income, i.e. $90 million on various goods and services. The recipients of the $90 million will in turn spend 90% of $90 million, i.e. $81 million and so on. At each stage in the spending chain people spend 90% of the additional income they receive. This process eventually ends with GDP rising by $1 billion, i.e. (10*100 million). 

In short, all that is required is to give every American more money to spend and this in turn should set in motion increases in consumer expenditure, which in turn will trigger increases in the production of goods and services. Observe that within the framework of 'the multiplier' savings are actually bad news. The more people save the smaller the multiplier. 

The magic of 'the multiplier' however, is just wishful thinking. Every activity in an economy has to be funded and therefore it is always in competition with other activities for scarce real funding. Hence if more is spent on consumption goods, less is left for capital goods. An increase in retailers' activity will be offset by a decline in the activity of capital goods producers. 

It is therefore not possible to lift the pace of general economic activity without an increase in the sources of funding. In other words, for a given pool of real funding any increase in some activities must mean less funding for other activities. Now if it would have been otherwise then by the magic of the multiplier we could have generated an almost unlimited prosperity.[1]

The proponents of the tax cuts are, however, of the view that tax cuts generate incentives to work harder and provide incentives for businesses to expand their activities. Again, without an expanding pool of real funding irrespective of tax cuts announcements no general expansion in economic activity can emerge. For every expansion in activity of some businesses, some other businesses will not have the required funding to embark on expansion. 

But surely the individuals who will be receiving checks would be able to spend more and thus lift the economy? Yes, they will be able to spend more at the expense of those individuals who will not get the checks.

A major driving force behind the increase in the pool of real funding is the real savings that fund the buildup of tools and machinery, which in turn makes possible an expansion in the production of final goods and services. With a greater pool more can be allocated towards consumption and savings.[2] With more savings it would be possible to enhance the production structure further, which in turn permits the expansion of the production of final goods and services—this is what economic growth is all about. 

Now, what does it mean to lower taxes? It means that Americans should have greater access to the pool of real funding. The only way this can be made possible is if government access to the pool is reduced. After all, in similarity to all other activities, government activities must also be funded. 

Thus when government decides to promote a particular activity, this means that the government will supply various individuals that are engaged in this activity with money. The received money in turn will permit individuals in that activity to access the pool of real funding. 

Since government is not a real wealth generator it relies on its sources of funding from the private sector. This in turn means that the more government spends the less real funding will be available for the wealth generating private sector. Obviously this will impede the creation of real wealth and impoverish the economy as a whole. Observe that if government could generate real wealth, it wouldn't need to tax the private sector.

The effective level of tax then is dictated by government outlays. The more government plans to spend the more real funding it will divert from the wealth generating private sector. The mode of diversion of real wealth from the private sector is, however, of secondary importance. What matters is that real funding is diverted. The method of taking real funding can be through direct taxes or indirect taxes and by means of monetary printing.

Another instrument for the diversion of real funding is by means of borrowing. But how can this be? After all if a lender transfers his real funding to a borrower surely this is done voluntarily? Furthermore, a lender should actually be seen as an investor. He commits his real resources in order to make a gain. This in turn implies that the borrower must be a wealth generator in order to be able to repay the original loan plus an interest.

This is however, not so as far as government is concerned. For government is not a wealth generator, it only consumes wealth.[3] So how then can the government as a borrower, which produces no real wealth, ever repay the debt? The only way it can do this is by borrowing it again from the same lender—the wealth-generating private sector. In short, it amounts to a process wherein government borrows from you in order to repay to you. 

It is therefore not possible to have an effective tax cut without a cut in government outlays. A so called tax cut while government spending continues to increase is just an illusion.  

Looking at the history of government outlays shows relentless increases. For 2004 the President's budget outlays stand at $2.229 trillion[4]. This is an increase of 19.8% on the outlays in the 2001 budget, which President Bush inherited from President Clinton (see chart). Per capita government outlays since 2001 increased by 17.2% (see chart).

So long as the pool of real funding is expanding various fiscal tricks appear to work—the muliplier seems to be the real thing. It is only once the flow of savings disappears all together on account of reckless fiscal and monetary policies that the facts of reality begin to assert themselves. Once this happens, irrespective of loose policies the economy falls into a severe slump.

In this regard, the government-compiled data indicates that the pool of real funding may be in trouble. Since 1986 real disposable income adjusted for imputations was below real consumer outlays. Consequently real personal savings, which are the difference between real disposable income and real consumer outlays, have been negative since 1986. In 2002 real personal savings stood at -$321 billion against -$363 billion in 2001 (see chart). The personal savings rate stood at -8.3% in 2002 against -9.8% in 2001 (see chart).

In addition to this, the widening in the state and local government budget deficit means that Americans will be paying more taxes to state and local governments, which are legally not supposed to have deficits. In Q1 the state and local government budget deficit stood at $66.9 billion against a deficit of $50.6 billion in the previous quarter (see chart).

Luckily for the U.S. however, some important contributors to government funding are foreigners. Out of the total federal debt outstanding of $6,198 billion in 2002 (see chart) foreigners held $1,106 billion (see chart), i.e. 17.9% of the total debt. There is a growing possibility that foreigners might lower their exposure towards the U.S. government debt implying that the American private sector would be forced to provide a greater portion of real funding to the government. For instance, according to the government's own estimates the Federal debt will jump to $7.3 trillion by 2004, an increase of 17.7% from 2002 and by 2008 the debt is expected to stand at $9.4 trillion, an increase of 51.6% from 2002. 

We can thus conclude that as a result of ever growing government outlays and the reckless monetary policies of the Fed, it is mission impossible to have an effective cut in taxes. That the intention is to grow rather than shrink the size of the government was demonstrated by President Bush's signing the increase in the Federal debt limit from $6.4 trillion to $7.384 trillion on the day he signed into law the tax cuts.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org.  Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Special thanks to Michael Ryan for his comments.

[1] Murray N. Rothbard. [1962] 1970. Man, Economy, and State. Nash Publishing. P. 759.

[2] Richard von Strigl. 2000. Capital & Production. Mises Institute. P. 18.

[3] Murray N. Rothbard. [1970] 1977. Power & Market. Sheed Andrews and McMeel. P. 173.

[4] James Ostrowski. "Is the Tax Cut for Real?" Mises Institute. May 29 2003.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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