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Why Tax Cuts Without Spending Cuts Won't Bring Economic Growth

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Tags Taxes and SpendingMoney and Banking

11/01/2018

On Monday October 15 2018, the US Treasury Department released figures showing that the federal budget deficit had widened by 17% in the 2018 fiscal year, to $779 billion.

Most experts see this widening in the deficit as the result of the tax cuts, which went into effect in January this year.

Note that the corporate tax rate was lowered from 35 percent to 21 percent while the income tax rate was reduced from 39.6 percent to 33 percent.

The 12-month moving average of the budget had a deficit of $64.9 billion in September against a deficit of $55.5 billion in September last year. In the chart below we can observe that the underlying budget deficit displays a visible widening.

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Some commentators are of the view that in the midst of strong economic growth a widening in the budget deficit could be bad news once the economy falls into an economic slump. Hence, these commentators are of the view that the lowering of taxes was a wrong policy at this point in the economic cycle.

Some other commentators hold that the lowering of taxes is going to boost economic activity, which in turn is going to boost government revenues and thus shrink the budget deficit.

However for the time being the 12-month moving average of the annual growth rate of government revenue continues to display a visible decline (see chart).

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The budget deficit is not the key issue

The key focus should not be on the budget deficit as such but rather on government outlays: it is not possible to effectively lower taxes without a reduction in government outlays.

This is because the government as such is not a wealth generating entity. In order to fund its activities it has to take resources from the wealth-generating private sector. Various individuals employed by the government expect compensation for their work. The government can pay these individuals by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for genuine economic growth. (We ignore here borrowings from foreigners).

To activate any government plan or any investment plan real wealth must be allocated for this. If during the execution of a plan, the current infrastructure does not generate an adequate flow of final goods and services, then the plan would have to be aborted.

Any attempt to go ahead with the plan will lead to an economic impoverishment (this is because part of the pool of real wealth is going to be absorbed by various non wealth generating activities. Now, if the current infrastructure does not adequately compensates for this, then this is going to put pressure on the overall pool of real wealth thereby weakening economic growth).

Fiscal Stimulus and Economic Growth

Since the government is not a wealth generating entity, then any tax cuts while government outlays continue to increase is not going to support a strengthening in genuine economic growth.

Now, fiscal stimulus could “work” if the flow of real savings is large enough to support i.e. fund, government activities while still permitting a growth rate in the activities of the private sector.

Hence, what is going to determine the growth rate in the months ahead is whether the pool of real wealth is still expanding? Irrespective of the tax cuts if the pool is stagnant or declining, then no sustainable economic growth is going to emerge.

Obviously, if the lowering of taxes is accompanied by the lowering of government outlays then less real wealth is going to be diverted from the wealth generators and this in turn is going to provide support for genuine economic growth. For the time being, this is not the case.

The 12-month moving average of the annual growth of government outlays still displays buoyancy (see chart). We do not have any indications that the Trump administration is planning to curb government outlays.

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If anything, the government is likely to boost its outlays to keep economic activity going. The possible widening in the budget deficit is likely to be monetized thereby reversing the presently observed weakening in the growth momentum of money supply, all other things being equal. This is likely to undermine the state of the pool of real wealth further thereby setting the economy for a serious economic shock.

Currently, the pace of economic activity in the US continues to display buoyancy. Some commentators argue that this is a direct result of the cut in taxes. Because most Americans are filling tax returns for 2017, then the impact of tax cuts will not be felt until next year.

Also, some experts are suggesting that many US companies as a rule take advantage of various loopholes — like being able to deduct the interest paid on loans — to lower their overall tax bill. So from this perspective the lowering of corporate taxes is hardly going to produce an effective result in terms of setting in motion an economic boost.

More likely, the observed strengthening in economic data is predominantly because of the past money growth rate.

For instance, the yearly growth rate of industrial production climbed from minus 4 percent in December 2015 to 5.1 percent by September this year (see chart).

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We hold that a major negative for the pace of economic activity in the months ahead is the declining trend in the annual growth rate of money supply since 2012 (see chart).

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If the pool of real wealth is in trouble then the declining trend in the money growth momentum could trigger a major economic shock when least expected.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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