Tax cuts key to sustained economic growth - The Centre for Independent Studies
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Tax cuts key to sustained economic growth

Political officials around the world, even in European welfare states, have discovered that offering tax cuts are not just a vote winner that can swing the outcome of an election. They are also a good way to spark sustained economic growth. So it is not surprising that President Susilo Bambang Yudhoyono has pledged to reduce both corporate and personal taxes to encourage increased investment in Indonesia .

Clearly he is looking beyond the bogus claim that cutting taxes benefits only the rich. Perhaps he and his advisers were impressed by the experience of other countries. For example, several economies that had veered far off their long-term growth paths during the early 1980s were revived by reductions in the marginal tax rate (amount of tax imposed on an additional unit of income).

For example, Turkey reduced its minimum marginal tax rates from 40 to 25 percent and the maximum from 75 to 50 percent in 1983 to 1984. Real economic growth was about 7 percent over the following four years and rose to 9 percent in 1990.

South Korea cut tax rates and expanded deductions three times, sparking a surge in economic growth that averaged 9.3 percent a year from 1981 to 1989. More recently, Ireland became known as the “Celtic Tiger” after a round of tax cuts.

And then there is the U.S. experience with cutting marginal income-tax rates in 1981 and in 1986. These sparked nearly two decades of relatively high growth into the late 1990s, interrupted only by a mild recession in 1990-91.

Evidence of positive “supply side” effects come from a recent report from the U.S. Congressional Budget Office (CBO). Using dynamic analysis to trace the effect of tax cuts changes on incentives, the CBO found that tax cuts increase investment and stimulate economic growth since keeping more of what they earn encourages people to people work harder and save more. In turn, increased growth and rising income will bring higher tax revenues with the largest benefits arising from lower marginal income tax rates or levies on capital gains.

The marginal tax on additional private income matters because it should take less effort to earn less than it does to earn more. In order to increase income, one should have to engage in more studies, accept more risk or responsibility, or relocate to find a better job.

Taxes affect corporate revenues by raising their costs. Since receipts on sales are limited by customer resistance to higher prices, attempting to raise prices to offset increased costs due to higher taxes or any other cause tend to reduce revenues.

This means that higher taxes will reduce the capacity to invest in R&D or expand the workforce or improve working conditions. Taxing corporate income can also drive marginal firms out of business so there will be less demand for labor and wages are lower and less output produced.

And so it is that high taxes and excessive regulation are among the most likely suspects behind slower economic growth since they inhibit entrepreneurial risk-taking. Fewer new investments and growth lead to lower overall living standards than they could be.

Permanent cuts in marginal tax rates combined with deregulation release the creative power of entrepreneurs to benefit most of the population.

Extra earnings come from producing more and better goods and services. A tax system that punishes added income also punishes increased output, thus reducing economic growth. If marginal tax rates are too onerous, the income tax system will curb productive activity or encourage a shift overseas or into “informal” activities.

Of course, there will be objections that cutting taxes will increase the fiscal deficit of the central government. But this ignores the fact that deficits generally result from free-spending politicians not tax cuts, per se.

Opponents of the Bush administration have blamed tax cuts for massive U.S. deficits that swept away virtuous surpluses accumulated by 2000. The truth is that when the GOP took control of both houses of Congress in the early 1990s, it halted massive spending proposals by the Clinton administration.

Meanwhile, the Fed followed a loose monetary policy that led to a large burst of inflationary spending. In the end, the budget surpluses of the U.S. government of the late 1990s were an inflationary phenomenon that evaporated as they all do — this time especially because of relentless pork-barrel spending.

Hopefully, the Yudhoyono administration will rely less on tinkering with interest rates in the vain hope of boosting economic growth and more on “supply-side” economic reforms. These include permanent decreases in marginal tax rates and reduction (or abolition) of capital-gains taxes to encourage business spending and provide a sustained increase in the demand for labor.

Tax cuts and deregulation also tend to lead to new capital purchases that increase productivity and raise real wages and standards of living. In the end, gains in nominal income lead to rising tax revenues that should more than offset losses from cutting rates.

Christopher Lingle, adjunct scholar at The Center for Independent Studies in Sydney, is professor of economics at Universidad Francisco Marroquin in Guatemala .