Why Tax Cuts Don't Work

The latest round of tax cuts, having done little for the economy besides widening our deficit even more, is the triumph of myth over history. What's remarkable is that despite all of the Post WWII evidence that interest rates hold far more sway over the economy, it's the "Reagan Economic Boom" of the 1980s that forms the underpinning of this fable. It's a remarkable tale of how millions can accept such a flawed premise as "common knowledge" if only it's repeated enough.

And the ones who kept repeating it are the "Three Stooges" of American economics, Arthur Laffer, Lawrence Kudlow and Stephen Moore, who aren't taken too seriously in the profession.

How do we disprove this theory? Even a caveman can do it.

Here's GDP (Blue) and the U-3 rate (Red) from 1950 to 1963.

What's remarkable about this chart? Those are pretty wild swings in economic performance over a period of time when marginal rates were frozen stuck just north of 90%. Just presenting a counterfactual here.

By comparison, look at the effect the cost of borrowing money has on the economy. When the Blue line (Fed Funds) trends up, the Red line (Unemployment Rate) soon follows up along with it. When rates are eased, people find work again and the "Un-rate" goes down. (1953 to 2011) Note the "miracle" occurring when Fed Chair Paul Volcker drops the Funds rate from its peak of 22%. Believe me when I tell you that if my Tanteh Rosie was President while this was going on, you wouldn't be flying into Ronald Reagan Airport.

This also begs another question: if your only policy response to rising inflation is tossing a few hundred thousand people out of work, you may want to consider the ramifications and find other tools.

Here's the performance of the economy after the Tax Reform Act of 1986, when the top marginal rate is dropped to a low 28%. Everyone is now trained to believe that since lower marginal tax brackets created the last "boom," doing even more of the same will be better still. Has to work, right?

Both GDP and the number of employed tank. By Q3 1990, we're into a recession, and more embarrassing for President George Bush, Sr., he consented to raising taxes, erasing a campaign promise he recklessly made.

So, why do rates matter more than taxation?

"Give a man a dollar and he'll hoard it. Let him leverage the dollar on the cheap, and he'll go to town and spend."

It goes without saying that businesses will react in precisely the same way. Why is this so? A bit behavioral. As long as that dollar is kept, the sense of security from holding a piece of collateral feels comforting to the holder, particularly if he's paid more to hold it. If the dollar is still in the bank, but a loan is floated against it, the psychology of ownership as a backstop has a powerful effect, even if the borrower goes a little too far on leverage. But the point is he's using the leverage to consume. Tax cuts never seem to do that, and there doesn't appear to be any empirical evidence of the economy improving in the wake of them.

Small wonder that even after executing a $1.5 TRILLION tax cut, almost double the size of the stimulus program instituted after the crisis started, the administration is urging the Fed to cut rates. The medicine isn't as effective as they told everyone. Best of all, the very same people who were urging the Fed to raise rates in 2008 while the economy was drowning, are now in favor of cutting them after it has recovered. Which is why they have no credibility with professionals in the field, as well as no sense of shame.

One of the first pieces I wrote for LinkedIn dealt with the expected effect on the economy of cheap gasoline. For those who remember, the price dropped to under $2.00 a gallon. For the first time in ages, I had the inconvenience of having to break a $20 bill for a fill-up. The sell side analysts went wild in expectations of a boom in retail from the savings realized. They could barely contain themselves. This chart kicked those expectations into high gear:

Even with the most optimistic calculation, the most people would see from this is an extra $60 a month, about the same as the lower taxed deciles received from the tax "reform" passed last year. It didn't change anyone's life, and the bets on retail lost money. It was supposed to "act like a Tax Cut." They were right, but they didn't get the irony.

Far bigger savings were realized from the Great Refinancing Binge of the post crisis years. Billions a month in mortgage payments were erased from homeowners' burdens, a savings bigger than any tax cut for the average wage earner. But even that didn't move the needle.

So why are tax cuts pushed as a panacea for the economy, even though the few people who see a palpable benefit from it don't even need the money?

That's the whole point.