Readers Question: How can tax cuts stimulate the economy when the government has to borrow the money? It seems to me that with a tax cut, the government is adding money to the economy but is also removing money from the economy by borrowing to finance the tax cut. So where is the stimulus?
It is an interesting question, and different economists may give different answers.
If the economy is close to full employment with a low saving ratio, then tax cuts financed by borrowing from the private sector could well ‘crowd out‘ the extra disposable income consumers have. However, in a recession, when saving rates are very high, then government borrowing doesn’t remove money from the economy because it was just been saved.
Therefore tax cuts are much more effective when the government is borrowing from unused cash reserves, which usually occurs during a recession.
In a period of strong economic growth, the private sector may be keen to invest in private business initiatives. If the government wants to borrow, it may have to compete with these other private sector investments. By borrowing money the government, therefore, reduces the amount of investment in the private sector. Therefore, although consumers may spend more because of the tax cuts. The private sector sees fewer funds for investment. Therefore, overall, there is no increase in aggregate demand.
Furthermore, if the government borrow more, this may push up interest rates on government bonds. This increase in interest rates can also have an effect on reducing aggregate demand and economic growth (it is termed financial crowding out)
Another issue is the idea that consumers may respond to tax cuts by deciding to save more. The reason is that rational consumers may see a tax cut financed by borrowing will lead to future tax rises. Therefore, consumers don’t spend the tax cut but save it for future tax rises. More on: Ricardian equivalence
Tax Cuts in a Recession
In a recession, people become nervous about investing. There tends to be a rapid rise in saving. People just hold onto cash rather than spending. This causes a fall in aggregate demand because people hold onto cash rather than spending.
In this situation, if the government borrow money from the private sector, they don’t reduce private sector investment because the money would only have been saved anyway.
Also, in a liquidity trap, government borrowing can increase, but interest rates still fall. (e.g. since 2007, UK and US have both increased borrowing, but bond yields have fallen). This shows there is a strong appetite for buying government bonds because the private sector wants to save)
A fundamental concept of Keynesianism is that governments should borrow to offset the rise in private sector saving.
Supply Side Effects
Some economists may say there is the scope for tax cuts to boost productivity. For example, a cut in the higher rate of income tax from 50% to 40% may encourage more people to stay working in UK and this increase in productivity can help economic growth in the long run. However, there is debate at what level tax cuts will boost productivity growth.
Tax Cuts v Spending Increases
It is possible, in some recession, tax cuts may just be saved by consumers and not spent. Therefore, there is little increase in consumer spending. In this case, it is argued government spending may be more effective in boosting demand.
Tax cuts lead to lower revenue. Tax increases lead to higher revenue.