The truth about tax cuts

As the debate over extending the tax-rate reduction bills of 2001 and 2003, usually referred to as the Bush tax cuts, rages on, let’s examine some of the arguments being promulgated and determine to what extent they are true.

Argument number one – increased tax rates mean more money in the till while tax cuts lead to decreased government revenue. This seems to make sense – higher rates should lead to higher collections and vice versa. But an economy is not a plot line graph that follows a predictable curve; rather, it is a complex and dynamic collection of individuals and their financial interactions. Individuals respond to both tax cuts and tax increases in ways that provide maximum benefit for themselves and their families.

Thus, people who consider themselves over-taxed will find ways to decrease their tax burden, perhaps by working less or moving. New York state found this out not long ago when it raised taxes on “the rich” and actually saw a drop in tax revenues. Governor David Patterson admitted, “We increased the income tax for millionaires last year. We projected that we would get $4 billion and we actually got well short of it.”

Conversely, when people consider their tax burden to be fair they will increase their productivity to maximize their income. The economic activity resulting from the Reagan tax cuts of the 1980s illustrates the paradoxical effect of lower tax rates.

“One of the apparently invincible fallacies of our times is the belief that President Ronald Reagan’s tax cuts caused the federal budget deficits of the 1980s,” according to economist Dr. Thomas Sowell. “In reality, the federal government collected more tax revenue in every year of the Reagan administration than had ever been collected in any year of any previous administration.”

Why was this? Sowell explained these cuts in tax rates per dollar, a more honest description than “tax cuts for the rich,” provided substantial incentive for individuals and business to increase their productivity and during the Reagan years the U.S. economy grew by more than a third, 34.3 percent. A larger economy translated into more tax receipts. Unfortunately, the deficit also grew because government spending outpaced higher revenues.

I actually hesitate to cite the above facts, despite their accuracy, because they almost give credence to a second argument - governments spend money more efficiently than private organizations and individuals. This argument is made implicitly by all those who believe more money in the hands of public officials is a good thing.

It’s important to understand money that stays in the hands of the people who earned it does not disappear from the economy. It is saved, invested or spent and a balanced combination of these actions supports a healthy economy. Since these decisions are spread over the entire U.S. population rather than concentrated in the hands of a few, chances are they will be more beneficial to the people who make them as well as to the businesses, communities and organizations with whom these financial interactions take place.

Economic behavior is complex – many volumes have been written on how people interact with money. But common sense tells us people spend the money they have earned through the sacrifice of their time and the use of their education and talents with more care and consideration than government bureaucrats do. Federally-funded projects are rife with waste, fraud and abuse of the taxpayers’ money. The more the taxpayers get to keep themselves, the better the chances their money will be spent wisely.

Argument number 3 - if the tax cuts are extended the government will be giving money to the rich. This phrasing is deliberately misleading. The people who benefit from the Bush tax cuts - and they include all Americans who pay income taxes - will not receive anything should the tax cuts continue. They will merely be allowed to keep more of the money they earned in the first place see above.) This is an important distinction, one that prompted Chris Matthews of MSNBC to take President Obama to task.

“He should stop saying that giving people tax cuts is giving people money,” Matthews said. “It’s their money.” He went on to clarify that people do not receive checks from the government when taxes are cut; rather, the government receives smaller checks from the people.

The government does not spend more money when it cuts taxes – it receives less. And there is the rub. When you or I experience a decrease in income we adjust our spending habits to accommodate the change. But this is something our government officials are loathe to do. When it comes to balancing the federal budget the reasonable and responsible strategy - spending less - is, for some reason, always the solution of last resort.