Sunday, February 24, 2013

Are Tax Cuts Good for Growth?

Just before the 2012 US federal elections, a bi-partisan congressional study investigated the economic effect of tax cuts found their effects to be of limited usefulness. While proponents of higher tax rates argue that revenues are necessary for sovereign debt reduction, and that higher rates on the rich mitigate income inequality, the conservative camp argues that low tax rates are positive for investment, innovation and growth.

Nevertheless, the study found higher tax rates to be correlated with slightly higher GDP per capita growth rates. Meanwhile, the effect tax cuts on GDP growth is either small, or non-significant.“The reduction in the top tax rates appears to be uncorrelated with saving, investment and productivity growth. The top tax rates appear to have little or no relation to the size of the economic pie. However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution,” concluded the report.

Senate Republican leader Mitch McConnell protested the study's ideological bias. It was subsequently removed from circulation by the Library of Congress.

Tax Reductions and Their Spending Cuts
Against this evidence the effect of cuts must be considered. According to an empirical study undertaken by the IMF, spending cuts are useful for reducing sovereign risk spreads. Nevertheless, gains realized via reductions in sovereign risk spreads are short-lived and subject to market-bias. In 2011, the IMF launched another empirical study casting a skeptical light on the merits of using reductions in sovereign debt service costs due to cuts as an economic growth strategy. 

Public expenditure returns on investment must be weighed against potential gains due to reductions in debt service costs. Taking all three studies into consideration, depending on tax cuts to deliver economic growth  yields little little-to-no long-term growth, while aggravating income inequality and increasing sovereign debt  - and private debt- service costs. In addition, the associated cuts generally lead to a contraction in GDP.   
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Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

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