Are tax cuts a free lunch?

June 1, 2000

The oft-repeated message that tax cuts will not decrease government revenues has a definite appeal. It says that not only can you have tax cuts, and therefore more disposable income, but there need not be any cost in terms of reduced public services.

The mysterious math behind these ideas should be treated with a great deal of skepticism. Even in the new millennium, there is no such thing as a free lunch.

Tax revenues grow primarily because of economic growth, which tends to boost revenues whether tax rates are going up or down. This is why you can always point to growing economies that cut taxes and witnessed increased revenues at the same time. But the idea that tax cuts cause so much economic growth that they pay for themselves is a delusion.

It is true that tax cuts, like spending increases, will give the economy a boost. However, the size of that boost will not be as big as some make make it out to be. In part, this is because government spending must be cut back at the same time (or else the deficit must increase). And part of any tax windfall will be saved, used to pay down the Visa bill, or will be spent on imported goods rather than in the local economy.

Part of any tax cut will thus end up back in government coffers, but reasonable estimates of how much revenue would be recouped are in the 20% to 50% range, over the medium-term. The BC Business Summit, while arguing for tax cuts, projected that only about 30% of their tax cuts would be recouped through the tax system (they recommend $1 billion in spending cuts in order to finance their tax cuts). These estimates are a far cry from the assertion that more than 100% of the tax cut would come back in increased revenues.

All of this means that if you cut taxes under favourable growth conditions, revenues may not drop in absolute dollar terms. But whether revenues will keep pace with the demand for public services, even just in terms of matching population growth and inflation, is a different story. The experience of Alberta and Ontario is that tax cuts went hand in hand with deep spending cuts, not enhanced public services. In other words, tax cuts do come with a price.

If there was a widespread consensus for the "free lunch" argument among economistsÑa very influential group in our societyÑour federal and provincial politicians would surely have pushed that button long ago. What politician could resist a platform of cutting taxes, thereby boosting revenues that could be used to enhance existing social programs, and even fund new ones?

These ideas were the centrepiece of Ronald Reagan successful campaign to win the White House. Tax revenues did increase after the Reagan tax cuts, but only after the economy came out of recession, and revenues increased by less than they would have in the absence of tax cuts. Meanwhile, the US economy underperformed CanadaÕs in the 1980s, US savings and investment rates fell, and the US national debt ballooned.

That the grand tax cut experiment did not deliver on its promises should be a lesson for British Columbians. The message that tax cuts come without a price may make for cunning political strategy, and it is a great way to sell upper income tax cuts to the general public. But the results are likely to be disappointing. If something sounds too good to be true, it probably is.

A broad look at the data shows that for the industrialized countries, over the post-World War II period, there is no clear relationship between tax levels and economic performance (measured as GDP, or GDP per capita). Fast economic growth rates can be found in high tax countries just as easily as low tax countries. Interestingly, a number of high tax countries (such as Denmark, the Netherlands and Norway) have out-performed the US in terms of GDP and productivity growth in the 1980s and 1990s.

The debate on tax cuts in BC and Canada is an important one because it is all about what kind of a role the public sector should play in society. If people want lower taxes and smaller government, then that is a democratic choice. But there is a price to be paid. The idea that "you can have it all" is misleading and detracts from the debate that we should be having.

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