Reasons behind Popularity of the Economic Fallacy - Essay Example

Economic Fallacy: Introduction Over the years some economical concepts have obtained huge popularity mostly due to their strong theoretical backing.But the interesting thing is that in practice empirical evidences do not provide adequate support to these ideas. In fact, in most of these cases empirical analysis of relevant incidences show the occurrences of the opposite things than what have actually been theorized and have become something like that of myths in the field of economics. These concepts can not be treated as economic facts, but as economic fallacies. One of the very common economic fallacies is that tax cut stimulates economy. Tax cut is widely perceived to be an effective stimulator of economic growth by the policy makers of any country. it is not the concept of tax cut has gained widespread attention only recently. In fact, since the time of rejuvenating the economy after the great depression in 1930s, economists have started to place huge importance on the policy of tax cut as this fiscal measure apparently seem to provide huge stimulus to the economy. At different points of time, economists of different backgrounds have advocated the policy of tax cut as one of the most effective measures of stimulating economic growth. In fact, if one considers the present economic scenario, one can easily found that a number of nations including the super power of the United States are resorting to the policy of tax cut to bring their economies out of recessionary state (Longley, 2009). But the problem associated with the idea of considering tax cut as a stimulator of the economy is that this idea is not an economic fact, it is purely an economic fallacy no matter how much popularity it has obtained from the economic theorists. It would be quite interesting to examine why and how such a wrong concept have gained such a huge popularity along with finding out why this concept is so wrong and does not hold good in reality. Reasons behind popularity of the Fallacy Huge popularity of the economic fallacy that tax cut provide a great stimulus to the economy stems from the fact that several economic theories proposed by economists of different back- grounds like Keynesian economics or supply-side economics, have advocated tax cut policy as an effective stimulator of economic growth. During the period of great depression in 1930s, Keynes had proposed the policy of significant government intervention in terms of increasing amount of government spending, reducing tax rates to solve the problem of lack of effective demand and unemployment. Apart from Keynesians, supply side economists, in spite of being major criticizers of Keynesian economics, also advocated an expansionary fiscal policy in terms of lower tax rate as a measure to boost economic progress. It would be quite interesting to examine how in the theories proposed by Keynes and supply-side economists, tax cut appears to be an effective measure of increasing economic output and thereby employment. Effect of tax cut in Keynesian economy: How a tax cut can increase output can be presented by applying a simple economic model known to be as Simple Keynesian Model. For the purpose of the analysis, suppose an open economy with government sector. In such an economy aggregate demand can be given as follows: Ad= c(Yd) + I + G + (X-M), where, AD stands for aggregate demand, c(Yd) represents consumption as a function of disposable income Yd, I is the autonomous investment, G is the autonomous government spending and (X-M) represents net exports. Here Yd, is equal to (Y – T + TR), where Y stands for total income or total output, T represents total taxes, and TR stands for transfer payment. For the simplicity of analysis, TR can be equalized to zero here. (Froyen, 2001) In equilibrium, total output produced should be equal to total demand. The equilibrium condition of the economy can therefore be given as follows: Y= c(Yd) + I + G + (X-M) …………………………………………………..(i) Solving equation (i) equilibrium level of output can be obtained. It will now be possible to discuss how equilibrium Y will be changed when there is a tax cut. Effect of cut in lump sum income tax: When lump-sum income tax or tax rate decreases, a lower proportion of the income of the consumers require to be paid in the form of taxes to the government. As a result, consumers re left with higher amount of money that they can now use for consumption purposes or savings. As disposable incomes get increased on account of decrease in lump-sum tax, demand for consumption also increases as consumption is positively related with income. However, increase in consumption will not be equal to the increase in disposable income as marginal propensity to consume is less then 1. Now as consumption demand rises, other things being equal, aggregate demand for communities in the economy also increases. Increase in aggregate demand provides a boost to the producers to produce and supply more products to the market as under higher demand, they expect their sell of commodities and services to increase also. As production rises, it is quite evident that employment will also increase. Hence, Keynesians suggest the fiscal policy of tax cut to boost an economy which is under recession. (Froyen, 2001; Larson, 2003; Dolan and Lindsey, 1991) Effect of tax cut in supply-side economy: Supply-side economists emerged as the major criticizers of the Keynesian school of economics. Unlike Keynesians, supply side economists placed their major emphasis on economic decision making process of individuals and the process through which government policies influence those decisions. According to the supply-side economists, incentives play a vital role in the shaping up of actions by the individuals. For example the price and the cost of consumption as against the price and the cost of investment significantly affect an individual’s decision. Supply side economists also consider supply before demand in process of economy. (Keating, 2001) According to them, supply creates its own demand. In supply-side economy, different types of supply-side endeavors like innovation, invention, risk taking behaviors, investments in capital, savings etc. are considered to be the major engines of growth of the economy. In supply-side economy, lower level of marginal tax rate is considered to be an effective fiscal policy that would boost economic growth of a country. Supply side economists think that tax rate imposed on one unit of additional income significantly affects economic decisions. Marginal tax rate plays an important role in the determination of the relative price of work in relation to leisure, or the relative price of consumption in relation to investment, or the relative price of risk aversion in relation to risk taking and so on. Consequently, supply-side economists have placed huge emphasis on the reduction of marginal income tax rate for providing increasing incentives to work, investment activities and risk taking activities. (Keating, 2001) Given, such strong theoretical foundations, the policy of tax cut have always been able to draw attention of economic policy makers whenever there have arisen any need of stimulation to economic growth. For example, recently as well as in past, U.S. have resorted to the policy of tax cut to boost its economy. Explanation of the fallacy Given such wide range of popularity of the economic view under consideration, it would be interesting to find out why it is regarded as a fallacy instead of a fact. To find out the ultimate effect of cut in income tax on the economy, it is necessary to examine the effect of the tax cut on the effects of the tax cut on the purchasing power of individuals as well as on aggregate supply of the economy. There is no doubt that imposition of tax on individual’s income deprives the individual of some amount of money that could have otherwise been spent to consume some goods or services. If reduction in spending in consumption was the only effect of taxation, then it would not be very difficult to conclude that increase in tax always produces negative effect on the economy. This is because, one’s spending represents another’s income and therefore drop in aggregate spending implies a huge drop in aggregate income of the economy which in turn implies increasing level of unemployment. (Kroeger, n.d.; Karier, 1997) In practice, the story, however, does not end here. It is true that increase in tax rate reduces individual’s ability to spend. But on the other hand, spending of government increases as the purpose of government of collecting tax revenue is to disburse it on various activities that are beneficial to the citizen itself. When through increase in tax, government spends more money, it get automatically converted to income to a significantly large number of individuals. hence, at the end of the day, increase in tax actually causes an increase in aggregate spending which in turn provides significant boost to the economy. the reason behind this is that, some of the money that are being received as income by some people from the government under increased level of tax revenues, would actually have been saved under lower tax rate, as some people, particularly the richer ones (marginal propensity to save is higher for rich people than that of poor people), had not used that money to pay taxes. Hence, it is quite evident that when government collects more through the imposition of higher taxes, then it would also spend more which in turn automatically pump more money into the overall economy. Now as spending increases, supply of output and therefore employment also rise. Hence, to determine the ultimate effect of tax cut on economy, the relationship between spending, saving and employment is very crucial. Advocates of tax cut have never realized the fact that when under a recessionary situation they recommend the policy of income tax cut, then actually propose a policy that would make the situation worse as the policy of tax cut is actually concretionary in nature because of the fact that richer people will actually save some of their extra amount of money arisen out of reduced level of tax payments. (Kroeger, n.d.) Conclusion On the basis of discussion above, it can be said that no matter how much theoretical supports are received by the concept that ‘tax cut boost economy’, the real picture is completely different. Even empirical evidences are against this concept. For example the tax policies proposed by Reagan or Bush in United States following the recommendation of the advocated of supply side economy, had not received any success in providing major boost to the economy of the country. (Campbell, 2005; Karier, 1997) References: 1. Kroeger, J. (n.d.) Do Tax Cuts stimulate the Economy? Available at http://nontrivialpursuits.org/economic_stimulus.htm [accessed on 2nd June, 2009]. 2. Keating, R.J. 2001. Understanding Supply- Side Economics: The Principles, the Policies, and the Future. Available at www.sbsc.org/media/pdf/policyseries2SupplySide.pdf [accessed on 2nd June, 2009]. 3. Froyen, R.T. 2001. Macroeconomics Theories and Policies. Singapore: Addison Wesley Longman. 4. Larson, J. S. 2003. Tax Cuts: Issues and Analyses. Nova Publishers. 5. Karier, T. M. 1997. Great experiments in American economic policy: from Kennedy to Reagan. Greenwood Publishing Group. 6. Campbell, D. A. 2005. bird in the Bush: failed policies of the George W. Bush administration. Algora Publishing. 7. Dolan, E. G. and Lindsey, D. E. 1991. Economics. Dryden Press. 8. Longley, R. 2009.The Economic Stimulus Package - How It Could Affect You. < Available at [ accessed on 7th March, 2009]. Read More