Not All Tax Cuts Are Created Equal

President-elect Obama reportedly may include $300 billion of tax relief in his so-called stimulus scheme. Political prognosticators think this will give fiscal conservatives a reason to vote for the proposal, but lawmakers who favor limited government should look before they leap -- especially if they actually want to improve economic growth.

The key thing to understand is that not all tax cuts are created equal. If policy makers want to boost growth, they need to reduce marginal tax rates on productive behavior such as work, saving, and investment. This "supply-side" insight is why the Kennedy and Reagan tax rate reductions were successful. It also is why flat tax jurisdictions such as Hong Kong and Slovakia enjoy such strong growth. And it is why zero tax regimes such as the Cayman Islands are beacons of prosperity.

Unfortunately, all reports indicate that the Obama plan will revolve around a gimmicky idea to give $500-$1,000 of tax relief to every household. Households certainly will be happy to receive this money, and I surely will cash any check that President Obama sends in my direction, but simply giving people money does not give them any reason to engage in additional productive behavior. And without more work, saving, investment, or production, there is no increase in national income.

Defenders of this type of scheme usually argue that distributing checks will result in people spending more money, which ostensibly will jump-start a sluggish economy. This is the Keynesian theory, but as this short video explains, it overlooks the fact that the government has to borrow every dollar that is being distributed to taxpayers or other recipients. So any money that is put in the economy's right pocket first has to be taken out of the economy's left pocket. Keynesian policies do not increase national income; they redistribute it. This, of course, is a pretty good summary of Obama's entire so-called stimulus.

Wait a minute, some of you may be asking, doesn't the same criticism apply to supply-side tax cuts? The answer is yes, but the argument for supply-side tax cuts has nothing to do with how much money people have in their pockets. Instead, advocates argue that the goal of good tax policy is to minimize the tax penalty on productive behavior. And if tax rates are low, then people will have an incentive to increase the quantity and quality of labor and capital they supply to the market. In other words, the goal of supply-side tax policy is to increase national income rather than to redistribute it -- the opposite of the Obama agenda.