The blogging bug is catching on at CCH.  One of our tax writers has written the post below focussing on the current financial crisis exclusively for CCHatter.
- Linda

In his recent book “The 86 Biggest Lies on Wall Street” John Talbott disagrees with the contention that tax cuts will stimulate economic development and increase tax revenues. According to Talbott the idea that tax cuts would increase the tax revenue is ‘almost laughable’.

Arthur Laffer’s idea on the interaction between tax cuts and tax revenue was based on the combined outcome of two effects: the arithmetic and economic effects. The arithmetic effect results in tax revenue falling with  cuts in tax rates and vice versa. The economic effect has the opposite outcome. It increases economic activity and thus leads to increased tax revenue. Depending on the size of the two effects, tax revenue may increase or decrease if a cut is made in tax rates.  (N.B.: Laffer was a member of President Reagan’s Economic Policy Advisory Board.)

In his article entitled “The Laffer Curve: Past, Present, and Future“ published in 2004 by the Heritage Foundation,  Laffer cites three periods of tax-cuts in the U.S as supporting his assertions; the Harding-Coolidge cuts in the mid 1920’s, the Kennedy cuts in the mid 1960’s and the Reagan cuts of the early 1980’s.  What is lost in the argument is the significance of the tax base. To quote from the article:

“At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would be willing to work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.”

The periods referred to by Laffer in his article were times when the U.S. was the last superpower standing.  Russia was on the back foot and Europe was experiencing  growing pains associated with expansion of the European Union. Asian giants  (China and India) have stirred but  were not galloping as now. The Dollar was dominant in the world markets and globalization has not kicked off, at least not at the current pace. But with unemployment rising and decimating the tax base in the U.S should not the Laffer hypothesis be viewed in that context?
In support of his opposing view that cuts in tax rates do not necessarily increase  the tax revenue, Talbott argues that because of his tax cuts Bush turned a $ 250 billion operating surplus from the Clinton administration into a $ 1.2 trillion operating annual deficit. This figure could very well top $ 2 trillion thanks to the Obama stimulus packages.

Isn’t there a major factor that is ignored in the debate: the  massive spending  in the U.S in the last decade or so.  Spiraling spending distorted the picture and led to massive deficits, despite the tax revenue.  Various global ventures in South East Asia and the Middle East  contributed to the burgeoning deficit in the U.S..  The book “The Three Trillion Dollar War” by Joseph Stiglitz and Linda Bilmes  says it all. As a matter of fact in the last decade U.S Government debt has doubled from $ 5 trillion to nearly $ 11 trillion. 

Could it still be argued that Laffer hypothesis is  fundamentally right?  If the existing tax  rates are higher than normal and the prevailing conditions favor economic activity it appears safe to  conclude that  tax revenue will increase eventually even if there is a tax cut. But unfortunately with  economic activity stalling and  unemployment increasing , tax cuts alone will not stimulate the economy and rake in tax revenue. Governments need to employ other measures to achieve a growing economy and hence increasing tax revenue.

Tax revenue in the U.S and Australia has been steadily growing. Taking the years 2000 to 2008, total internal revenue collected in 2008 in the U.S  is 1.3 times that in 2000  whereas in Australia it is 1.6 times. Is this sufficient reason to embark upon a round of significant tax cuts or should governments continue to fill the state coffers to ward off future distress?

The Federal Government in Australia has introduced two new measures to boost the economy: Investment tax breaks and improved small business capital gains tax concessions.

Investment tax break rules allow deduction in respect of investments made by businesses. These measures will allow businesses to invest for the future and yet claim tax relief in respect of their expenditure. Without merely cutting the tax rates these measures are expected to enhance economic activity, increase the tax base by increasing employment and consequently increase tax revenue.

Tax cuts alone will not have the desired effect.

Tags: economics, opinion, tax writer

To post a comment, click here

This entry was posted on Thursday, August 13th, 2009 at 2:01 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.