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Higher Taxes = Deficit Reduction? Not Necessarily

By Karen Sanders

A The Washington Post article today reports that letting the Bush tax cuts expire would nearly close the fiscal gap. This static logic misses two key dynamic aspects of the economy: (1) the political incentives that higher taxes bring about, and (2) the economic incentives of such policy.

1. Political Incentives. With higher revenues initially coming in from higher taxes, there would be a stronger political incentive to increase spending. That is, taxpayers have no guarantee that their higher tax payments would actually go to deficit reduction. If history is any lesson, it is more than likely that Congress would lever up on the higher tax revenues, expanding the government even more with borrowed funds. The net result: Deficits would remain, but now there would be an even higher level of overall debt.

2. Economic Incentives. Why is there a call to put a tax on carbon? Because some believe that we should use less carbon. If the tax works and people use less carbon, what happens to the revenue from a carbon tax? It decreases. Similarly, if you place higher taxes on labor and capital income, you get less labor and capital income. Therefore, the dynamic revenues from the higher tax rates would actually be less than expected. Furthermore, the economic harm from discouraging the very activities that contribute to the growth of the economy (i.e., create income by using our resources to produce, save, invest, and innovate) would put the economy on a slower growth path that would weaken the U.S.’s competitive position in the global economy.

It is critical that the government implement policies that take account of the way incentives— and therefore decisions—change. In a dynamic economy, these small decision changes create feedback effects that can snowball and change the growth path of the entire economy.

A slower growing economy hurts everyone, as the recent economic recession so detrimentally demonstrated. Unfortunately under the new tax policy, this slower growth would no longer be considered recessionary; we and our children would view it as “normal,” never realizing all the growth opportunities that would have led to higher incomes, more job opportunities, and new goods and services to enjoy. In an ever-changing and adapting economy, these are the opportunity costs that should be considered.


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