FUNDAMENTAL TRUTH #79: “Tax cuts stimulate. Not tax hikes.” -Old Pithy

Posted by PITHOCRATES - August 16th, 2011

Government can only Spend what it Taxes away from the Private Sector

What stimulates?  Tax cuts?  Or tax hikes?  Ronald Reagan believed it was tax cuts.  But everyone one on the Left poo pooed Reaganomics.  ‘Trickle-down’ economics only stimulated rich people, they said.  Those on the Left prefer Keynesian stimulus.  Tax and spend.  To take some of that money the government pulls from the private sector.  And spend it to stimulate the private sector.

What did we learn from the great 2011 debt ceiling debate?  And the subsequent S&P credit downgrade?  This.  Government is spending beyond its means.  Those on the Left say this is due to insufficient taxation.  Those on the Right say we’re spending too much.  That’s neither here nor there for our purposes here.  I only mention it to emphasize a point.  Government can only spend what it taxes away from the private sector. 

For the government to stimulate the private sector economy, then, it must first tax money out of the private sector.  So let’s take a look at a proposed stimulus plan.  Let’s say the government revises the federal withholding tax rates so that there is a net 5% increase in the effective tax rate (tax revenue divided by income).  And let’s put these numbers into a chart like this:

 

Let’s say all numbers are millions of dollars.  The effective tax rate changes from 20% to 25%.  And tax revenue increases by $25,000.  (Effective tax in the above chart.)  That’s the additional amount they pulled out of the private sector.  That they will use for government stimulus spending.  Now the government has to process this.  Through a large bureaucracy.  Let’s say that these ‘overhead’ costs are 15%.  Subtract that from the stimulus amount.  And you have $21,230 left.  To stimulate the economy. 

So they pull $25,000 out of the private sector economy.  So they can inject $21,250 back into it.  Which means the net stimulus added is a negative $3,750.  That’s right.  They added money to the economy.  After removing a larger amount from it first.  And that’s Keynesian stimulus.

Keynesian Spending favors the Politicians, not the Private Sector

This is actually opposite of what a stimulus is supposed to do.  Which explains why Keynesian stimulus spending fails.  But it’s even worse than this.   Because those numbers above are for a best case scenario. 

They don’t take into account pork and earmarks that make up most of a stimulus bill.  Such as the Obama stimulus bill.  Which proved to be more a Democrat wish list of repressed wants for some 40 years than shovel-ready stimulus.  And the 15% overhead is something you see in the private sector.  Not in a government that pays $300 for a toilet seat.  So let’s factor these more realistic numbers in.

 

The numbers are much worse.  By increasing taxes 5% you actually pull 8.63% out of the private sector economy.  There is no stimulus.  That’s a net deficit.  And a lot of pork and earmarks for the politicians.  And to make things worse, this additional spending finds its way into baseline budgeting.  Which means that they increase the current deficit.  And all subsequent deficits. 

That doesn’t favor the private sector.  That favors the politicians.  Which is the goal of Keynesian stimulus spending.

The Beauty of Tax Cuts is that the Money doesn’t go through the Sticky Hands of Government

So we see that Keynesian stimulus favors the politicians over the private sector.  Is there another form of stimulus that actually favors the private sector?  As it turns out, yes.  Tax cuts.  Let’s look at cutting taxes instead of raising taxes. 

The beauty of tax cuts is that it doesn’t require the money to go through the sticky hands of government.  So a tax cut of $25,000 equals a stimulus of $25,000.  The money remains in the private sector.  And we pull no money out of the private sector.  So this is pure stimulus.

The net add to the private sector economy is 6.25%.  Which is 14.88% better than the Keynesian approach.  (Going from a 8.63% decrease to a 6.25% increase).  So it’s clear which way to stimulate is better.  It’s a no brainer.  So why don’t the diehard Keynesians admit defeat?  Simple.  Tax cuts don’t go through the sticky hands of government.

Tax Cuts stimulate the Private Sector, Keynesian Spending stimulates Government

The Keynesians will no doubt say this is an oversimplification of stimulus.  And it is.  But the fundamentals remain the same.  Government stimulus spending is funded by the private sector.  Either by higher taxes to pay for the stimulus.  Or by higher taxes to pay for the cost of borrowing the stimulus.  And if the government just prints the money for the stimulus, a depreciated dollar makes everything cost more in the private sector.  Whatever they do the private sector will lose in the long run.  Because they ultimately pay the bill.

Tax cuts don’t have this affect.  Because you don’t have to pay for tax cuts.  The money never belonged to the government in the first place.  So they don’t have to pay for it.  The private sector just gets to keep what is rightfully theirs.  But the Keynesians will cry that if you cut taxes you will increase the deficit.  Yes, you may.  But no more than you would by borrowing money to pay for Keynesian spending.  Either way the government is spending beyond its means.  The government should cut spending.  But if they don’t, they should at least pick the option that will stimulate the economy.  The option that grows the economy.

The goal of stimulus is to stimulate economic activity in the private sector.  And as the exercises above show, the best way to do that is to leave more money in the private sector.  Not less.  Tax cuts stimulate the private sector.  Unlike Keynesian stimulus.  Which only stimulates government.

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