The Problem with Cutting Taxes without Reducing Spending

According to many economic experts and commentators, an effective way to generate economic growth is through the lowering of taxes. The lowering of taxes, it is held, is going to place more money in consumer's pockets thereby setting in motion an economic growth. This way of thinking is based on the popular view that a given dollar increase in consumer spending will lift the economy’s 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. 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 the GDP rising by $ 1 billion i.e. (10*100 million).

In short, all that is required is to give every individual 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 - since the more people save the smaller is the multiplier.

The magic of ‘the multiplier’ however, is just wishful thinking — a myth. Every activity in an economy has to be funded and therefore it is always in competition with other activities for scarce real savings. Hence, within all other things being equal if more is spent on consumption goods, then less is left for capital goods. An increase in retailers activity will be offset by the decline in the activity of capital goods producers.

It is therefore not possible to lift the pace of economic growth without an increase in the pool of real wealth. For a given pool of real wealth, any increase in some activities must mean less funding for other activities. If it would have been otherwise then by the magic of the multiplier we could have generated almost unlimited prosperity.1

The proponents of the tax cuts are of the view that tax cuts generate incentives to work harder and provide incentives for businesses to expand their activities. We suggest that without an expanding pool of real wealth, 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.

Surely, individuals who will be receiving money 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 money.

Note that the increase in the pool of real wealth funds the build-up of tools and machinery, which in turn makes possible an expansion in the production of final goods and services. With a greater pool, more could 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 individuals should have a greater access to the pool of real wealth. The only way this can be made possible is if the government’s access to the pool is lowered. The government’s demand for funding must be reduced. After all, in similarity to all other activities, government activities must also be funded.

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 wealth.

Now the 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 wealth 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 then obviously it would not 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 wealth it will divert from the wealth generating private sector. The mode of the diversion of real wealth from the private sector is, however, of secondary importance. What matters is that real wealth is diverted. The method of diverting real wealth can be through direct taxes or indirect taxes or by means of monetary printing.

Another common instrument used for the diversion of real wealth is by means of borrowing. A lender who commits his real resources in order to make a gain should be seen here as an investor. This means 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. It amounts to a process wherein government borrows from you in order to repay to you. (We ignore in this discussion borrowings from overseas).