Intro: Conventional economic thought, with its narrow focus on spending, argues that if a government cuts taxes without lowering spending, then real GDP growth will benefit as there will be more overall spending in the economy. While more spending will likely result, this spending will be in nominal and not in real terms, reflecting higher inflation and increased imports thanks to the increase in money and bond supply. In real terms, tax cuts that are not backed by spending cuts can lead to unsustainable economic booms that give way to recession.
When governments give across-the-board tax cuts with the intention of supporting economic growth and in the absense of spending cuts, this can set off a boom-bust cycle that ultimately leaves the economy worse off than it would otherwise have been. In the case of corporate tax cuts, entrepreneurs may see an increase in monetary profits, which acts as a signal for them to boost investment. However, it should be kept in mind that no additional land, labour, or capital has been made available as government spending has not concomitantly fallen.
The perceived increase in profits that entrepreneurs see due to the tax cut does not reflect an increase in productivity as a result of increased resource availability among the private sector, but rather the fact that input costs have yet to rise. Over time, as entrepreneurs go out and acquire the inputs to expand production, they find that the additional spending power simply drives up costs, and therefore profitability tends to be less than was originally perceived. The tax cuts effectively fool entrepreneurs into believing that their expansion plans made possible by lower taxes are commensurate with an increased availability of inputs, causing them to undertake investments that they wouldn’t otherwise have done under higher taxes. Such investments often therefore turn out to be unprofitable, causing a subsequent downturn.
In the absence of spending cuts, if one business receives a tax cut, that business finds its 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. However, the same is not true for the economy as a whole. If every business is given a tax cut, just like if every business is given free money, no company is made better off, unless the tax cut reflects reduced government spending and thus an increase in resources available to the private sector. If this wasn’t the case, we would have eliminated taxes long ago, along with poverty.
There are exceptions to the rule that tax cuts in the absence of spending cuts are net negative for the economy. If, for instance, there is a high unemployment rate and tax cuts are focused in areas that reduce the marginal disincentive to work, then they may ‘pay for themselves’ by increasing economic output. Similarly, if tax cuts can encourage foreign direct investment then this can result in faster growth. However, generally speaking, tax cuts aimed at boosting short-term growth tend to result in subsequent economic busts.