Sunday, January 04, 2009

Fiscal Stimulus Part 3: Federal Spending v Tax Cuts

Harper/Flaherty are floating the idea of trying to stimulate the economy with tax cuts rather than federal spending.

The IMF disagrees, saying that tax cuts are less effective than government spending. Tax cuts can be a small component of the total package to target specific aspects of the economy, but cannot be relied on as major stimulators. In addition, there is almost always a delay in implementing a tax cut.

Here are some suggestions I've seen floating around recently:

Cut all corporate taxes for one year
This will create windfall profits for some companies, but it won't cause much new investment because there isn't time for investment to be implemented before the tax break is over. It will not help companies that need help - they're already losing money and so paying less or no taxes. The windfall profits will result in some job savings and investment, but they may be as temporary as the tax break. Much of the profit windfall will be sent to corporate HQ (often in the US or elsewhere), be distributed to international shareholders, be used as management bonuses, and so on. There are also fairness implications. For example, self-employed people can choose whether to incorporate or not, and there is currently very little tax difference: it would not be fair if suddenly all the incorporated people got a 100% tax reduction, while the sole proprietors did not. (That's one of many examples of unfairness that would be created.)
Conclusion: Ineffective, expensive and unfair

Further cuts to the GST
When Harper cut the GST two years ago, every economist in the country said that it was a poor move because it would not stimulate the economy. Then it didn't stimulate the economy. I don't know why we're still talking about this idea. The IMF has specifically warned against cuts to value added taxes like the GST on the grounds it will not create stimulus.
Conclusion: Completely ineffective

Cut taxes to poor people
This is the most effective form of tax cut, as poorer people are less likely to save any extra funds they get, and in addition more of the money will be spent on domestic (rather than imported luxury) goods. However, poorer people pay less tax, and also the tax method will result in a delay. It would be more effective to increase transfers than cut taxes. A recent article in the Toronto Star argued for increasing "the Canada Child Tax Benefit, the refundable GST credit and the Working Income Tax Benefit". The IMF recommends "extending unemployment benefits, increasing earned income tax credit or equivalent tax cuts targeted to households that are likely to be credit constrained, and expanding social safety nets." I favor permanent changes to employment insurance and welfare, which create automatic stimulus whenever the economy starts to sink, as well as helping those most in need.
Conclusion: Increased transfers would be quicker and more effective

Some people have got stuck in the idea that private spending is somehow more effective for stimulating the economy than public spending. Paul Krugman refutes that argument here.

An equally important consideration is that of fairness. Fairness requires that the tax structure should be as stable as possible. When we know how we will be taxed, we can plan around it. When there are major changes to taxation, there's a lottery effect: some people win big, but other people lose (think of the recent debacle over income trusts). Governments must be much more careful about changing taxes, and only change them to achieve long-term goals.

See also:
Fiscal Stimulus Part 1
Fiscal Stimulus Part 2: Size

1 comment:

susansmith said...

Excellent analysis and the way forward. Positively progressive. I had to chuckle, with all the reduction in corporate taxation for the past 10 years, and again, the request of more of the same, it would appear that reducing corporate taxation induces recessions/depressions.