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Can Raising Taxes Improve The Economy?

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In an earlier post, we considered whether tax rate increases can spur economic development from a historical vantage point. From a conceptual vantage point, it is also evident that tax rate increases can spur economic development.

Currently, U.S. effective tax rates (the actual tax liability as a percentage of income)* are nearly the lowest since entering WWII and among the lowest in developed countries. Why does this seem contrary to what you might hear in the media? Because when pundits and politicians complain about U.S. tax rates being high in comparison to other countries, they’re often referring to the marginal tax rate – the highest tax rate that applies to an income bracket. The difference is what is really paid. For example, many developed countries assess taxes that the U.S. government does not, such as surtaxes, capital taxes, and VAT (akin to a sales tax), in addition to their federal income tax. Likewise, many developed countries do not offer the generous deductions and credits permitted by the U.S. tax structure.

What about state taxes, you might ask? Well, most developed countries have taxes at the provincial, state, or other municipal level. As such, their comparative effect is generally neutral.

Media reports and corporate Financial Statements show that businesses have been conserving cash rather than reinvesting in the business. (Economist, The WSJ.) According to the reports, these businesses are not initiating new research and development, replacing or adding to assets, nor hiring additional personnel. Businesses do not drive economic growth when their spending does not increase. Instead, that’s stagnation.

Similarly, when government spending contracts – as is currently proposed in the U.S. Congress, it spends less on people, on assets, on investments such as infrastructure, and on business development such as SBA loans. Even worse, it can lead to a contraction of future growth as investments in education, including college financing, is also cut. Growth, by its definition, means expansion. Expansion cannot occur if children are learning less than their parents – that too is a contraction.

When the price of products rise, as they are currently, and wages do not, the lack of business reinvestment and government spending can lead to stagflation (the economy slows or does not grow while the cost of goods increase).

When businesses are unwilling to spend, and individuals are unable to increase their purchases, the only institutional source for economic growth is through government spending. Government programs employ people. Government investment improves or creates new assets, often assets that reduce the cost of companies to do business, such as better roads, bridges, or less expensive yet more efficient forms of transportation or communication. Further, government spending (grants) or investment (loans) on business development help other businesses expand that would not have the capital to expand otherwise, translating into more jobs and greater production and consumption.

There are two primary ways in which governments can raise money: taxes or debt. (Pundits and politicians often exclude a third, yet potentially short-sighted avenue from discussion – the sale or leasing of assets and services.) The current political environment eschews raising debt. Reducing debt without increased tax revenues means decreased spending. When all other things remain the same, this translates into economic contraction. However, the government can maintain its level of spending while cutting its debt by raising taxes.

As mentioned earlier, the U.S. effective tax rates are low. Yet, businesses are not reinvesting the money they earn – reinvestment is a common argument against raising business taxes. As such, there is flexibility for the government to raise taxes without impeding business development. In fact, by raising taxes and putting the cash to work, the government is more likely to increase business development to the extent its non-debt expenditures increase.

For those concerned about businesses fleeing the U.S. if it raises its corporate tax rates, consider the following. First, the U.S. is the largest market by nearly every measure. Businesses would be foolish to not pursue a profit in the U.S. (because U.S. income tax is net of profits, it does not extinguish profit generally). Second, the U.S. will be an even more attractive market if its economy not only expands but expands at a rate faster than the other developed countries that are implementing austerity currently.

Additional Resources: Historical marginal corporate tax rates (IRS)

Additional Reading: How Offshore Tax Havens Save Companies Billions (NPR)

*Effective tax rate (ETR) as used in this publication is different from the effective tax rate you’ll see in a company’s financial statements. ETR in financial statements includes deferred income taxes – taxes companies expect to pay in the future – as well as foreign, state, and local taxes.

Originally published 20 March 2011



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