A recent IMF paper finds that while tax cuts for the very wealthy may stimulate growth, they also have the polarising effect of increasing inequality.
The International Monetary Fund logo is seen inside its headquarters at the end of the IMF/World Bank annual meetings in Washington, US, October 9, 2016. Credit: Reuters/Yuri Gripas
New Delhi: US President Donald Trump has now repeatedly said, in various different ways, that he will be pushing “major, major tax cuts” for individuals in Congress, the exact nature of which are unknown. He also said he would cut “the business tax rate as much as possible, ideally [to] around 15%”. These cuts are apparently meant to stimulate growth, because of the increase in demand due to the tax saving.
Democrats and several economists have argued that such tax cuts will have little positive effect on growth while benefiting only the very rich, leading to increased inequality.
Criticism of the policy to cut personal income tax rates for the very rich recently has also come from another source. The International Monetary Fund (IMF), known for its conservative neoliberal economics and fiscal policy recommendations, has published a study on September 1 (before the US Congress restarted after its summer recess of September 5) which concludes that tax cuts for the very rich just aren’t worth it.
It’s not like the study has gone so far as to say that tax cuts don’t have any positive effects. In their model, which they say is based on the US economy, they find that tax cuts for the very rich do stimulate growth. However, the benefit goes entirely to the very rich, thereby increasing inequalities. The authors of the study, Sandra Lizarazo, Adrian Peralta-Alva and Damien Puy, have said in a policy paper to go along with the longer article:
In our simulations, while tax cuts for higher income groups may generate greater gains in GDP through higher investment and labor supply, they also exacerbate income polarization and inequality, both already at historical highs. Even accounting for the fact that rich people might consume more goods and services produced by people in the lower part of the income distribution, and allowing for an increase in the earned income tax credit to protect the poor, the income gap would still widen substantially if taxes were cut for higher income groups. (emphasis added)
Tax cuts for middle-income households, the authors have gone on to argue, make much more sense in their model. A middle-class personal income tax cut, they argue, will not only stimulate growth (though less than the cut for the wealthier could have), it will also reduce income inequality. How? The paper says:
Both middle and low income households profit from a tax cut that is targeted at middle income groups. The tax cut generates an increased demand for non-tradable services which raises the demand for—and the wages of—low-skilled labor. This trickle-down mechanism implies that tax cuts, at least when applied to the middle-class, can have a progressive impact in general equilibrium and help reduce income polarization.
The IMF paper’s model assumes that all services are non-tradable, an assumption that many economists have questioned for years now (including some from the World Bank). Another – and even more significant – assumption the paper makes is “that the loss in income tax is paid for by a cut in wasteful government spending (that has no feedback into the model),” which means that they are assuming that a reduction in government spending will have no negative impact on demand. But a cut in government spending is bound to have some adverse effect on economic activity – any spending on the government’s (or anyone’s) part – however “wasteful” – involves demanding some goods or services, so reducing that means reducing some demand. This, in turn, will have effects on both economic activity and government revenues. So the effect will depend on whether this decline is offset by the expected increase in demand from those whose taxes are reduced. By ignoring this impact, the IMF’s assumptions are creating an almost model environment for tax cuts. But even in that very favourable environment, it finds that personal income tax cuts for the very rich have a polarising effect.
The study also looks at how tax cuts will be financed. That’s important because it questions the Ronald Reagan-era assumption that tax cuts pay for themselves. As Greg Jericho writes in the Guardian:
The idea of self-funding tax cuts got a big run in the 1980s under Ronald Reagan. He argued that his policies, which slashed the top tax rate in the US from 70% to 26%, would pay for themselves through increased growth. They didn’t.
In 2006, a US treasury study found that the tax cuts caused revenue to fall in real terms and was only partially made up by other tax increases that Reagan introduced.
But the myth of tax cuts paying for themselves remains.
The current US treasury secretary, Steven Mnuchin, said in April that economic growth would pay for Donald Trump’s tax cuts; in the same month Liberal senator James Paterson told the Senate that “the revenue collected from individuals after the tax rates were cut [by Reagan] in fact increased rather than decreased”.
The IMF study finds that no tax cuts have growth or investment effects that are strong enough to make up for the loss in revenue. The cuts, the authors argue, will have to be financed by “increasing the public debt, cutting spending, or by raising revenues from other taxes”.
This particular IMF paper, while discussing the utility of different kinds of personal income tax cuts, does not mention that other fiscal policy approaches can also be used to stimulate an economy. However, previous work by the IMF has taken this into account and found that especially during recessions, fiscal multipliers tend to be higher when the expansion is led by public spending rather than by tax cuts. A 2012 IMF working paper looking at G7 countries excluding Italy found that “fiscal multipliers differ across countries, calling for a tailored use of fiscal policy” depending on the state of an economy. In times of a downturn, the paper says, public spending has a larger multiplier effect than it does otherwise. Another paper, published in 2013 and written by former IMF chief economist Olivier Blanchard and Daniel Leigh, finds that “actual fiscal multipliers have been larger than forecasters assumed”. Government spending was one of the fiscal multipliers they were considering.
Given that even the IMF has recognised that tax cuts for the rich increase economic inequality, it may be time for people in the US, particularly Trump’s working-class supporters, to start looking at his proposal a bit more sceptically.
