With President Trump’s proposed tax cuts on the table, the conservatives are making their traditional argument that increased government revenues from increased economic growth will offset reduced tax receipts from lower tax rates, and will prevent the budget deficit from increasing. Tax cuts pay for themselves, they argue. Tax cuts do grow the economy, but they do not pay for themselves.
There is a virtual consensus among some commentators that this is a truism. For example, Treasury Secretary Steve Mnuchin stated that “the tax plan will pay for itself with economic growth.” The White House’s Council of Economic Advisers published a recent study showing that Trump’s proposed cut in the corporate tax rate would boost the typical family’s take-home pay by at least $4,000 per year. Tax experts at Boston University and MIT said in a recent paper that tax cuts would boost wages by 4% to 7%, after inflation.
Additionally, it is virtually universally undisputed that various types of tax cuts could increase nominal revenues. But in fact, they can’t. The notion that tax cuts could increase revenues, or wages, is a myth.
The idea that a growing economy will increase government revenues is most commonly expressed by the Laffer Curve, a graph which depicts a tradeoff between tax rates and government revenue, and implies that lower tax rates mean increased government revenue.
The problem with the Laffer Curve and the argument that revenues increase with economic growth is that they assume a growing economy results in greater monetary incomes that provide greater tax revenues. It does not—that is to misconceive what economic growth actually is.
The common assumption is that economic growth is manifest in companies and individuals receiving higher revenues and wages and therefore having higher incomes on which to pay higher taxes to the government. On the contrary, an economy grows by increasing the quantity of goods and services it produces—companies produce things; they do not produce money. Economic growth increases real incomes, not money incomes. Creating more goods does not create more money. Only the central bank creates money.
So the conservatives are wrong to argue that the increased economic growth generated by tax cuts would result in greater money incomes that, when taxed at the lowered rates, would result in government revenue that (at least) equals the revenue from the previously lower incomes taxed at higher rates. Instead, the economic growth the tax cuts would cause results in more goods and not in more money (the value of tax cuts is that they free up capital that would otherwise be taxed, so that it can be used for production instead of consumption). Therefore, there would not be higher money incomes to tax at the lowered tax rates. There would simply be the same money incomes taxed at lower rates, resulting in less government revenue. Thus, to prevent the budget deficit from increasing, tax cuts would need to be offset by spending cuts.
If economic growth doesn’t increase money incomes, how is it that our money incomes increase? Indeed, the confusing relationship between producing more goods (i.e., economic growth) and earning more money needs some explanation. The Federal Reserve or any central bank merely adds money to an economy as it grows. By adding to the amount of money in circulation the central bank pushes up wages, prices and revenues; but that is a separate, if sometimes simultaneous, independent activity. More money can be added or not while economic growth is taking place, and economic growth may or may not take place when the money supply is increased (look around the world, and you’ll see that countries have different combinations of money growth and economic growth).
But it is not an increased amount of money that makes an economy grow; what makes an economy wealthier is instead the increased capital—from tax cuts, for example—that is used to increase the supply of goods and services per capita, which, in turn makes everything cost less. Therefore people can buy more with the money they have and are thus wealthier in real terms. When the money supply is increasing—and thereby causing prices to rise—at the same time that economic growth is occurring, the nominal price of goods increases, but more slowly than wages increase (because the supply of goods per person is increasing). Thus, real incomes increase because the things people buy cost less relative to their incomes, regardless of the monetary level of incomes and regardless of the amount of price inflation. It is real incomes that increase with economic growth and make us wealthier, not nominal money incomes.
The misconception that economic growth brings higher incomes derives from the habit of expressing economic growth in monetary terms, and losing sight of the actual production taking place. Conservatives can perhaps be forgiven for their confusion, as this misleading accounting practice is common, not least on Wall Street where analysts do measure and report economic growth in monetary terms. It is this accounting error anomaly that inclines analysts to believe that economic growth brings greater revenues and profits to companies, and makes stock prices go higher. In fact, however, those increased incomes—as well as the higher stock prices—are the result not of increased production, but of increased money supply from the central bank available in the economy.
Politicians, political analysts, and others on both or all sides misunderstand what economic growth actually is and how it is manifest in the economy. Therefore they fail to grasp that lower taxes do not result in higher incomes or increased government revenue, but instead in greater productivity. A better understanding of the true relationship between taxes and economic growth could result in better tax policy.