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Does a Tax Cut Help the Economy?

Wednesday, May 10, 2006
The question of today is whether a tax cut actually helps the economy. To be more precise, I am talking about a tax cut without a proper cut in government spending to correspond. While the current administration, and most administrations for that matter, would really like you to think that a tax cut is the best for the economy, there are two sides to every story.

Those that are for tax cuts say that a tax cut will give the consumer more money in which to spend on goods that will create more jobs, which sets off a whole multiplier effect. Keep in mind the government taxes each of these transactions, so the multiplier effect goes down 30-40% in net taxes each time. This is not necessarily a wrong way of thinking, because it will often work in the short term.

The only problem with a tax cut is that there are other things besides this effect going on at the same time. Since a government can either raise money by taxation, or borrowing via the bond market, if the government lowers taxation, which means they have to increase borrowing or decrease spending. Since Congress probably won’t decrease spending anytime soon, that means we are increasing borrowing.

Once there is an increase in government bonds, the rate at which these bonds will have to go up to increase more purchasers to buy up the government debt. If the interest rate on this debt goes up, that will entice institutions and other investors to buy bonds from the government instead of stocks, or bonds from businesses. The result of this is that the tax cut causes a business to have to have a greater rate of return in order to make debt payments, or get investors. The effect on the bond market gets more rapid as this policy goes on.

Keep in mind that all of these factors depend on the actual values of the markets, and they can have a net impact that is insignificant based on the current economy. The idea of this article was more to show how there are two sides of the equation when dealing with macro economic issues.

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