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August 9, 2010
The Tax Cut Trap
Picture a see-saw or a balance scale. On the right side is a single twelve pound weight. Let us say that is represents a sound and stable economy.
On the left side of the scale is a stack of little weights each weighing from a few ounces to a pound or two. The total of the assorted weights is eleven pounds and thirteen ounces. The scale is decisively tilted toward the twelve pound weight on the right.
Now, add a mere six ounce weight to the left and the balance immediately shifts to the left.
What caused the shift? Many would argue that the last six ounce weight caused it, but it would obviously not have made the decisive impact if it were not for the multitude of weights already weighing on the left side. All of the weights together caused the shift though no single weight on its own would have made a difference.
That in essence is the fallacy of considering a policy in isolation. This fallacy applies to those who think we are just another stimulus away from a turn around as well as to those who think a tax cut will solve our problem.
Clinton raised income taxes and the economy boomed. But he also cut taxes on dividends and capital gains, taxes associated with the wealthier Americans. Success, however, is knowing what worked yesterday, and the economy in 1994 is very different from the economy today.
Reagan's tax cuts combined with the taming of inflation also stimulated a boom. But that boom was aided by a shift of money from tangible assets accumulated after a decade of inflation to financial assets. This drove down interest rates which made the deficits far more tolerable.
But that was then. Today we have record deficits and low interest rates, and very little in the way of tangible assets, especially with the collapse in real estate, ready to power a shift into bonds and equities. What worked then may not work as well today.
A mere three percent tax increase on the wealthiest Americans certainly would not really affect the motivation of American entrepreneurs, would it? Certainly a three percent higher tax rate would not have kept Steve Jobs from creating those wonderful iPhones and iPads. Probably not, but without the investment capital from the venture capital firms, Apple may never have gotten off the ground. And those venture capitalists were very much influenced by tax rates. In fact the 1980's saw a proliferation of new startup small businesses that reacted quite strongly to the flood of capital into the financial sector.
Since the two most recent examples of successful tax cuts, we have been piling weights on the left side of the scale at a furious pace. Tightening of credit, higher taxes and regulation from the health care bill, higher minimum wages and unemployment benefits, serious consideration of the union card check bill, threat of higher taxes on income, capital gains and dividends, cap and trade legislation, frightening debt levels and the relentless anti-business attitude from both Congress and the President all have combined to stop business in their tracks.
Because we have tilted the scale so heavily to the left (literally and figuratively), merely cutting taxes will not likely stimulate business growth like it did under Coolidge, Kennedy, Reagan and Clinton. Business is still too shocked and the drastic growth in regulation is a greater burden on the small businessman, the real engine of the middle class because they are less able to manage the political risk (such managers are called lobbyists) than the larger companies. Unless the tax cut is large, quick, and long lasting it is just too small a weight to affect the balance.
Businesses can manage risk but they cannot manage chaos. We have destroyed the faith in Washington's ability to keep a consistent stable set of rules to play by. No business will make a long term commitment when they face drastic changes in the rules every election cycle.
While merely cutting taxes may not likely be enough to stimulate this economy, raising taxes in a fragile economy is foolish, especially the sharp increases in capital gains and dividend income while unemployment remains so high. Modern history is rich with examples of reduced revenues as a result of higher rates.
Taxes cannot be considered in isolation. This economy is different in many ways. For a tax cut to have a meaningful impact we will have to move many other weights off the scale. If we do not we risk seeing a tax cut becoming that last six ounce weight, taking the blame for an accumulation of failed policy; and removed from consideration for years to come.
But no one will benefit from continuing to add weight to the wrong side of the scale.