Investing in tax cuts rather than paying government debt

Contrary to widespread claims, there is no evidence that lower budget deficits or budget surpluses that lead to government debt-reduction will benefit the U.S. economy, says economist John H. Makin. But there is evidence that lower tax rates stimulate economic growth by encouraging more investment and work effort.

For instance, in the 1982-1987 period of lower tax , and higher deficits and debt, the economy grew an average 4.5 percent annually – a full percentage point above the long-run average growth rate of 3.5 percent.

But from 1993 to 1998, after taxes were increased to reduce the budget deficit, economic growth averaged 3.8 percent.

With the prospect of $4.2 trillion in budget surpluses over the next 10 years, it makes better economic sense to use at least some of that money to cut taxes – especially with the tax burden at a record peacetime average of nearly 21 percent of gross domestic product (GDP).

Conservatively estimating spending $1 trillion on tax rate reduction would add 0.5 percentage points to the growth rate, raising the underlying average from 3.5 percent to 4 percent, what would be the financial effect?

Raising economic growth one-half of a percentage point would add $3.44 trillion to total GDP over the coming decade.

That is, a $1 trillion reduction in federal tax revenues would add $3.44 trillion to total GDP – for a rate of return of 13.1 percent a year.

The $3.44 trillion in extra GDP would generate $689 billion in federal tax revenues.

Thus the net revenue reduction for the federal government would be $311 billion, enough to leave surpluses intact. That represents a fabulous rate of return of 27 percent per year.

If the $1 trillion tax rate cut boosted average annual growth by 0.7 percent, there would be no net loss of federal revenue.

Source: John H. Makin, The Mythical Benefits of Debt Reduction, AEI Economic Outlook, September 2000, American Enterprise Institute, 1150 Seventeenth Street, N.W., Washington, D.C. 2003, (202) 862-5800.

For AEI text http://www.aei.org/eo/eo12032.htm

For more on National Debt http://www.ncpa.org/pd/budget/budget-6.html

For more on Effects Of Tax Cuts http://www.ncpa.org/pi/taxes/tax21.html

RSA Note:
The most important aspect of this article for South Africa is that lower taxes increase economic growth – to such an extent that the growth generated can result in total tax receipts that exceed what was previously received. Budget deficits are not good for economic growth as they cause inflation, which deters long-term business planning and investment. South Africa needs a steady reduction in government spending, taxes, budget deficits, and inflation in order to bring about high growth – and general support for a Minister of Finance with the courage to do all these things – someone like Trevor Manuel.

Eustace Davie, Director