As macro policies go governments have two main tools to implement them: fiscal and monetary policy. Since the start of the current crisis in 2007 both of them have been used in an attempt to push up aggregate demand. Until now the results are not what anyone would reasonably expect from looking at the public debt growth and from key policy rates near zero. Basically, policy makers supplied fiscal shocks one after another (increased government expenditures) while monetary policy accommodated those shocks by increasing money supply (lowering interest rates).
Going forward economists are offering depending on their convictions and political aspirations either more government spending, an even looser monetary policy or a combination of the two.
However, there only few voices advocating lower taxes. Why is this so and how would this work?
Cutting taxes leads to higher cash balances for the private sector (households and companies) but also for the public sector employees and state owned enterprises. There are two main immediate effects of lowering taxes are: higher cash balances and lower government revenues. Regarding the first one those higher cash balances will either be spent or saved. In the same time the government can continue spending as before or cut spending to adjust for the lower revenue.
Let’s walk through the 4 cases and see what is the expected end result for each one of them.
In the first case extra cash balances are spent and the government continues to spend as before. The effect from higher consumption will lead to economic growth in the very short term. This effect is amplified by credit growth as more people and companies qualify for more debt. In the same time the government will have to borrow to pay for the same/increased spending. In the first years revenue will not fall as much on the back of economic growth. However, over time the government will have to borrow more increasing the public debt. As public debt grows financial markets will start increasing the cost of funding. The end result will just be default unless economic growth will be higher than the interest rates at which the government borrows. We know that beyond some level of growth this outcome is impossible.
Turning to the second case, when the public saves and the government continues spending as before, the main difference is that we do not benefit from the short term growth (details in the 4th case). Thus the end result, default, is achieved much faster.
The third case is the one where cash balances are spent and the government cuts spending in response to lower revenue. Thus we benefit from economic growth but more importantly from a lower budget deficit which in turn will lead to a lower and lower public debt. Lower public debt means lower interest rates which will put the economy on a higher potential growth path increasing the welfare of all citizens.
Finally, the fourth case will lead to the same result as the third one but with some delay as in the first instance cash balances are saved. This will lead after some time to lower cost of funding due to higher pool of savings and then to increased investment which will lead to economic growth. Again, we end up with improved welfare but it will take longer than in the case when cash balances are spent immediately.
The four cases are presented in the table below.
|Private Sector/Public sector employees|
|Government||consume/continue public spending
default but delayed by short term increase in growth
|Save/continue public spending
Default faster as there is no immediate growth effect
|Consume/cut public spending
Increased welfare faster due to immediate growth effect from consumption
|Save/cut public spending
Increased welfare but after a longer period as there is no immediate growth effect
From the table it is easy to see that the best outcome is when cash balances are spent and government cuts spending while the worst outcome is when the extra cash balances are saved while the government continues to spend as before.
Of course we do not know ex ante which of the 4 cases has a higher probability. What we do know, and it is very important, is that irrespective of what the private sector does lower spending due to a cut in taxes will lead to improved welfare.
Why then we do not talk about lowering taxes as a solution to get out of the economic crisis and promote growth? My answer is that policy makers know that they will not cut spending in response to lower taxes. In fact they also know that every 4 years they will have (from their point of view) increase spending to ensure re-election. Thus, although we all know what the best outcome is the behavior of the policy makers, dictated by their objective function, gives the highest probability to the default scenarios. Under these circumstances it is not optimal for policy makers to advocate lower taxes.
Nevertheless, the society should strive to change this and push policy makers towards lower taxes and lower government spending as the best solution to achieve higher welfare. One way is to vote most of the time those candidates that promote this policy mix – lower taxes, lower public spending. Over time we will end up in the lower part of the table presented above.
Finally, I have not talked about monetary policy at all. Does it matter what monetary policy does in this case? Let’s see. To same extent it does, similar to the case when fiscal stimulus takes the form of higher government spending. Much like in that case monetary policy will have to accommodate some of the lower taxes. But not as much as in the government spending case. The really positive outcome of lower taxes is that households and companies can increase consumption and investment via more credit. Thus the work of monetary policy will be done by the banking sector and in this way we end up with lower inflation expectations.
Lowering taxes followed by a cut in government spending in the same proportion is a superior solution to increasing government spending when we try to maximize the welfare of the economy. This result is derived from lower inflation expectations and lower probability of default over time.