Intro: Tax cuts in the absence of spending cuts tend to lead to an increase in GDP in nominal terms but not in real terms as additional bond issuence/money printing needed to finance the deficit leads to higher inflation. Additionally, the the deficits thar result can undermine economic health as they result in rising levels of government debt which must be paid for eventually either in the form of inflation or austerity, increasing the likelihood of economic shocks.
It is tempting to think that if government spending is 20% of GDP and taxes fall to 15%, with the deficit rising to 5%, businesses and consumers will have higher levels of profitability and disposable income respectively. To be sure, if one business receives a tax cut, they will find their after-tax profitability has improved and so will likely expand investment, much in the same way as if the business had been given free money. Similarly, if one consumer receives an income tax cut it will find that their disposable income has risen and will likely expand consumption.
Free Money For Everyone Equals Free Money No One
However, the same is not true for the economy as a whole. If every business/consumer is given a tax cut, just like if they are given free money, no business/consumer is made better off in real terms.
In the example above, all that happens is the additional nominal income received by businesses and inividuals is offset by higher prices as the government must increase bond issuance or money creation in order to purchase the 20% of GDP worth of goods and services from the private sector. Although it is true that the government’s deficits translate into savings for the private sector in monetary terms, in real terms they do not. If this was not the case, we would have eliminated taxes long ago, along with poverty.
While low taxes seem unequivocally positive for economic growth, there is more to it than meets the eye. Low taxes are good if they reflect a low level of government spending thus allowing the private sector to invest and grow. If spending is high and taxes are low, this will tend to undermine growth over the long term by resulting in high levels of government debt, which must be paid for by inflation or fiscal austerity. In the case of the former, high debt will limit the ability of central banks to increase interest rates due to the threat posed by higher debt servicing costs. In the case of the latter, high debt loads mean that tax hikes or spending cuts will have to come, creating a potential economic shock.
It is also worth adding that if a government runs a persistent fiscal surplus, this is not some kind of drag on economic growth. If taxes are higher than spending, one of two things will happen. A) the government will use these savings to invest in overseas assets, so external savings will rise and provide a steady form of income back into the country. B) the money will remain in the treasury’s coffers and effectively out of the money supply, so the after-tax earnings that citizens receive become worth more in real terms.