George Bush was a President tarnished by the financial crisis and the failure of the Iraq War. Elected on the promise of a Conservative revolution akin to the 1980s, Bush vowed to shrink the state further and he failed in this goal. Pursuing Keynesian economic policies, the deficit exploded as his tax cuts were unable to successfully promote economic growth proportional to the reductions. A failure to curb wasteful spending, increasing government spending as a share of GDP contributed to its ineffectiveness at stimulating economic growth; similarly, how the government introduced them, gradually and temporarily, made the policy less effective. Unlike his Republican predecessors in Coolidge and Reagan, the Bush tax cuts weren’t a roaring success.
Tax-cutting Successes
Successful tax cuts spurred long-run economic growth through a more efficient allocation of resources is plentiful in history; the Coolidge tax cuts of the 1920s are a prime example. Under his tenure, the top tax rate fell from 73% to 24%; the national debt (outstanding) declined from $22 billion to $18 billion as tax revenues grew from the explosion in economic growth and activity. As the private sector allocated resources to more effective use (as a pose to government bureaucrats’ wasteful sending), productive transactions took place on a grander scale, promoting employment and income growth in what became known as the Roaring Twenties.
More recently, Reagan drastically simplified the US tax code during the ‘Reagan Revolution’ of the 1980s. The top rate of tax was slashed from 70% to 28%, eliminating loopholes and deductions. Tax revenues increased as a wave of economic growth was birthed. By eliminating exemptions and needless tax credits, the bureaucratic tax system was vastly simplified, making the tax system more efficient and effective. High tax rates impede research and investment; limiting deductions removes tax incentives that would otherwise favour one sector over another, allowing resources to be allocated to where they are more efficient.
As with the Coolidge tax cuts, a more efficient market allocation of resources followed, putting capital in the hands of more productive businesses and individuals and promoting economic growth.
Ricardian Equivalence
David Ricardo famously revolutionised world trade. Primarily espousing the benefits of free trade, Ricardo promoted the idea of comparative advantage and specialisation; countries specialising in what they can produce at a greater quantity and quality can trade with one another to make each other better off. Ricardo also promoted the idea of Ricardian Equivalence; a tax cut without a proportional spending reduction led to businesses and individuals anticipating a future tax rise to compensate for a growing budget deficit.
This phenomenon became apparent under Bush. Businesses that make decisions over extended periods of time, need to calculate future demand. As an unfunded tax cut is seen as a tax deferral, the government borrowing crowded out private consumption, investment and activity, rendering the tax cut ineffective.
Crowding Out
Financing a government deficit requires the issuance of government bonds and a greater supply pushes bond prices downwards, raising yields in the process. As such, deficit spending raises interest rates in the economy.
By manipulating the Aggregate Demand equation (AD=C+I+G+X-M), we get: AD=G-rP (Where G=Government Spending, R=Market Interest Rates in an economy, P=Private consumption/investment). From this, we can see any increase in government spending (an unfunded tax cut is equivalent to expenditure as it requires bond issuance), and as interest rates rise, private expenditure will be offset. This assumes credible monetary policy – an inflation-targeting Central Bank will move its interest rates following the market interest rate to nullify any stimulative effects of this fiscal policy.
Any increase in government spending comes at the expense of private consumption and investment. While the tax cuts were introduced for this exact purpose, the growing budget deficit financed by the private sector meant that the tax cut didn’t promote private activity.
Time Lag & Withdrawal
The initial tax cuts of 2001 were gradually introduced. This had a dramatically negative effect on GDP as consumers opted towards saving their additional disposable income. In 2003, the gradual phase-in was ended, leading to a significant increase in GDP, investment, consumption and working hours – promoting the case that instantaneous tax reductions are more effective than gradual cuts. The previous Coolidge and Reagan tax cuts were immediate, further supporting this case.
By making the Bush tax cuts temporary, this further damaged its positive effects. Stable, predictable tax systems are essential for the price mechanism to efficiently allocate resources. As aforementioned, businesses invest in view of future demand; if tax cuts are announced as temporary, firms become far less willing to invest as they anticipate a shortfall in demand. Economists agree that policy uncertainty reduces economic growth. Although, Obama later partly extends the Bush tax cuts, it was impossible for businesses and consumers to foresee this during its heir introduction.
A misguided focus from a Keynesian effect also reduced its effectiveness. Viewing tax cuts from an aggregate demand perspective is misguided as mentioned earlier; Central Banks offset any increases in aggregate demand deemed inflationary with contractionary monetary measures, rendering any fiscal stimulus futile. Bush failed to reconcile this.
“By leaving American families with more to spend, more to save, and more to invest, these reforms will help boost the Nation’s economy and create jobs. When people have extra take-home pay, there’s greater demand for goods and services, and employers will need more workers to meet that demand.”
George bush: 2003 address
Marginal incentives matter when enacting tax reform. Keynesians don’t distinguish between giving a worker earning $10,000 paying 30% on their taxes a $1,000 tax credit subsidy, or giving that same worker a tax cut to 20%. Each policy provides the worker with the same take-home pay; however, the incentive structures are vastly different. The tax reduction plan is clearly the preferable plan of the two, improving the incentives to earn more money, promoting long-run economic growth. Improving the work and invest through simplifying the tax code, eliminating loopholes and deductions while cutting marginal rates produces a less bureaucratic tax system, increasing revenues and long-run growth by a more effective incentive structure.
Ultimately, the failure of the Bush tax cuts can be attributed to his inability to curb spending and the way in which the reductions were introduced. Through the crowding-out effect, any giveaways to the private sector saw a proportionate fall in private sector activity by those funding the increased budget deficit. The tax deferral that defines deficit spending limited business investment as future demand became uncertain, as did its expiration. A misguided focus on increasing aggregate demand instead of long-run aggregate supply further exacerbated the problem, tarnishing the previously (almost) spotless historical success of tax cuts.
Free Marketeer 