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Tax Cuts

Tax Cuts

BY HASAN DIWAN
Prevailing US economic theory states that tax cuts are good for the economy. But there is no mention of what time period the theory refers to. While, they'll stimulate the economy short-term, I believe they will lead to inflation long-term. I'll illustrate this using a mathematical example (using MathML), but first I'll explain the assumptions which must be made in order for this model to hold.</p>

We must first assume that a tax cut will lead to no increase in saving. While I realise this is not a realistic assumption, the only change one has to make is take a fraction of the total tax cut amount for individuals.

On to the model, assume the US government decides to give every taxpayer a $500 tax credit. Based on our assumption above, this means that an individual's disposable income goes up $500. This injects $500 x 300 million or 150 billion dollars into the economy. Savvy shopkeepers will quickly realise that they'll make more profit by increasing their prices next time they are updated (this is referred to as "menu cost"). This is what economists call inflation.

Most economists acknowledge that long-term inflation is not a good thing. So, long-term, the country will need a tax increase to keep the money supply constant.

So, why do Republicans scream about tax cuts? It's good politics. Take the 2002 tax cuts, for instance. They are only in effect till 2006. At which point, there will have to be a tax increase. Also, since Bush doesn't get to run for a third term as president, he won't care.

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