Print Edition - 2015-02-01  |  Free the Words

Tax talk

  • The government can make good use of either a tax cut or a raise only if it makes good investments
Tax talk

Jan 31, 2015-

One of the most interesting debates in economics is whether cutting taxes induces consumption to stimulate an economy or not. A tax cut ?nanced by government borrowing has multiple effects on the economy. In the short run, higher consumer spending would raise the aggregate demand for goods and services and thus raise output and employment. In the long run, the smaller national savings caused by the tax cut would mean a smaller capital stock and a greater foreign debt. Therefore, the output of the nation would be smaller, and the budget deficit higher due to a greater share of output owed to foreigners.

Forward looking

Some economists take the ‘Ricardian’ approach named after the economist David Ricardo and suggest that a tax cut by itself would not stimulate consumer spending. The Ricardian equivalence proposition is an economic  hypothesis which holds that consumers are forward looking so they internalise the government’s budget constraint while making their consumption decisions. This means, for a given pattern of government spending, the method of financing that expenditure does not affect the consumption decisions of the agents. This approach concludes that  tax cuts do not stimulate consumption and nor do they change aggregate demand. These economists believe that consumers may be far-thinking and base their spending decisions not only on their current income but also on their expected future income. They save the extra income from the tax cut rather than consuming out of it because they think the tax cut is temporary and that government borrowing today means higher taxes in the future. A tax cut ?nanced by government debt does not reduce the tax burden; it merely reschedules it. It therefore does not encourage the visionary consumer to spend more.

So the question is, do consumers consume the tax cut or save it? This depends on consumer behaviour. Are consumers really far thinking? Ironically, Ricardo himself doubted that that people were rational and farsighted enough to think of their future tax liabilities.

Some examples in history have shown that tax cuts do not necessarily stimulate an economy whereas in some cases, such as the Regan tax cut of 1981 in the US, a tax cut had been successful in stimulating an economy.The economic boom in the US lasted for 92 months without a recession, from November 1982 to July 1990, the longest period of sustained growth during peacetime and the second-longest period of sustained growth in US history.

The opponents of tax cut policy say that cutting taxes reduces government’s revenue and hence, creates more deficit which is bad for the future of the economy. Economist Arther Laffer argues that the economy may be at a point where cutting taxes may actually raise the government’s revenue by increasing the taxable base. Thus, the debate between the traditional and Ricardian views of government debt and fiscal policy is ultimately a debate over how consumers behave.

Nepali case

In the context of Nepal, it is necessary for the government in the right areas. The focus should be on stimulating domestic demand which has helped many other countries grow and prosper. Nepal should make necessary economic reforms in order to boost demand that will build a more competitive economy.This can benefit businesses and consumers alike. Cutting corporate tax may be beneficial to motivate investors. Encouraging foreign direct investment instead of focusing on foreign aid could be another step towards economic growth. Improving ways to collect Value Added Tax (VAT) can also help the government to increase revenues.  Even a reduced VAT rate could help generate more revenue if the taxable base is increased.  Also, a tax cut even if it reduces government’s revenue may boost the economy by stimulating aggregate demand. On the other hand, not cutting taxes may increase government’s revenue but not do any good to the economy if the government cannot invest in the right areas such as technology and education. Thus, the cause and effect of making any economic decision needs to be analysed properly. If the government is to raise its revenue, there must be better transparency on the process of collection.

Siwakoti is a student of economics at the Agnes Scott College, the US

Published: 01-02-2015 09:27

User's Feedback

Click here for your comments

Comment via Facebook

Don't have facebook account? Use this form to comment