Wednesday, October 4, 2017

What Is The Relationship Between Tax Cuts And GDP Growth?

The US economy is near full employment but the Trump administration has proposed large cuts in taxes to expand the economy.  That raises a general economic question about the use of tax policy to stimulate economic growth.  This article examines the ways in which tax cuts might stimulate economic growth by examining the relationship between taxes and the inputs to the economy.  Republican tax cut proposals are typically based on the assumption that lower taxes will increase the supply of inputs to the economy.

One of the inputs to GDP is the supply of labor.  Supply side economists argue that reducing individual income taxes will increase the supply of labor.  That's a difficult argument to make in full employment economy, but it might be a good way to stimulate growth if there is a strong relationship between the supply of labor and the after tax price paid to labor.  Most of the research on this top shows that the price elasticity of labor supply is close to zero.  That is, increasing net wages by cutting the individual tax rate will not increase the supply of labor.

Capital is another input to GDP.  Its hard to measure the supply of capital but dividends to shareholders are a payment to the owners of capital.  The relationship between dividend payouts and growth in the supply of capital is close to zero.  Business investment in new capital has not grown in response to cuts in the tax on dividends.  Business executives tend to invest in new capital in response to the demand for their products and services.  The fact that interest rates are very low also suggests that the economy is fully capitalized.  Interest rates would rise if businesses were borrowing funds to increase their supply of new capital.

Investments in R&D might increase innovation and productivity.  That would increase the rate of economic growth.  The tax plan proposed by the Trump administration is focused on cutting the corporate income tax.  The elasticity of demand for R&D and the corporate tax rate is close to zero.  However, the proposal to allow corporations to write off capital investments faster might have some effect on capital investment.

Financial transactions such as buying and selling stocks and other assets do not increase output.  However, services are provided for those transactions.  The prices paid for commissions etc. do contribute to GDP.  Reducing the tax on capital gains from financial transactions might increase the number of transactions but this would not have a big effect on GDP.  Some have even argued that a transaction tax that was used to fund government spending would stimulate growth.

In summary, tax cuts in a full employment economy will not increase the rate of economic growth.  Supply side approaches are not the best way to grow the US economy.   

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