BUDGET DEFICITS AND TAX CUTS III

In my previous post, I concluded with findings by Mankiw that if consumers are uncertain about their future incomes and tax liability, Ricardian Equivalence may fail. This assumes that deficits are produced from the tax cuts.

What if there are no deficits? Then there will be no need to raise taxes in the future and no reduction in output in future periods.

Often the Regan tax cuts are cited as an example of poor public policy. The mantra goes that tax cuts for the rich generate deficits, which in turn lead to higher interest rates and a sour economy. The poor suffer, in addition to economic growth.

However, if government consumption stays constant, a tax cut now may not require an increase in the future if tax collections actually increase such that no deficit occurs. This may happen if marginal tax cuts increase the after tax value of the marginal product of labor and after tax marginal productivity of capital, leading to more production and output. With more output, a larger taxable revenue base results in more tax collections.

Lawrence Lindsey ( 1987) noted that for incomes greater than $200,000 per year, the Regan tax cuts lead to an increase in reported incomes and increased collections. For those earning > $200K per year, we saw the following increases in collections:

1982 – 3%
1983 – 9%
1984 – 23%

In his book ‘The Vision of the Annointed', Thomas Sowell points out the following: ( he obtained this info from ‘Budget of US Government: Historical Tables'. U.S. Government Printing Office, 1994.)

YEAR REVENUE in billions
1981 599
82 618
83 601
84 666
85 734
86 769
87 854
88 909


Each year, in the face of, and in the wake of large tax cuts, revenues increased. Therefore, it seems we have a situation with marginal tax rates where either Ricardian Equivalence will hold approximately, or tax cuts for the wealthy could actually have a simulative effect. I suppose we could reach a point ‘on the laffer curve’ where tax cuts would not lead to an increased revenue response. In that case, if RE fails as Mankiw believes, negative effects from deficits could occur.


REFERENCES:

Robert Barrow. Macroeconomics- 5th Edition MIT Press 1997

Lindsey, Lawrence B. 1987. “Individual Taxpayer Response to Taxcuts, 1982-1984.” J. of Public Economics 33 (July) 173-206

Thomas Sowell. ‘The Vision of the Anointed.’ (1995)