What Tax Cuts Do

The Obama tax deal with Republicans is insane

Tony Wikrent, Real Economics

Wednesday, December 8, 2010, 8:54 PM

If you look under the hood of the industrial economy, you easily see why there is this counter-intuitive relationship between tax rates and economic growth . With high taxes, the only way to retain the bulk of the wealth created by a business is by reinvesting it in the business — in plants, equipment, staff, research and development, new products and all the rest. But if tax rates are low, then there is more incentive to pull the wealth out, by declaring it as profits that are taxed at what turns out to be too low a rate. In other words, low taxes create an incentive for profit taking.

If tax rates are high enough to discourage profit taking – forcing wealth created by a business to be recycled back into the business – then businesses are pushed toward longer-term planning, as they invest in new plant and equipment that will be used for many years. And you do not get the absurd situation you have now, where companies are posting record breaking profits, but are not buying new equipment, nor hiring new employees.

Low tax rates encourage taking wealth out of industrial companies; the wealth taken out must then be “put to work.” That means more money chasing “investment” opportunities, leading to price increases in financial capital or real estate or some other asset. In other words, an asset bubble. The rise in prices of an asset bubble has nothing to do with the creation of real wealth. It all looks like prosperity – until the asset bubble bursts. That’s where we are now.

Is it that simple?  Yes, yes it is.  It’s just that simple.

I encourage you to read the whole thing which also includes 3 great historical failures of low tax policies and a prescription for a modest financial transactions tax to further encourage investment in capital (as opposed to financial) assets.

(h/t Corrente)


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    • TMC on 12/09/2010 at 16:54

    Obama is giving the Republicans more hostages.

    December 2011

    (But) the new deal creates another hostage situation – this time for December 2011, when the good stuff in the deal is scheduled to run out.

    Look at the Zandi estimates: they show a boost to the economy in 2011, which is then given back in 2012. So growth is actually slower in 2012 than it would be without the deal. . . . . .

    Now, what we know from lots of political economy research – Larry Bartels is my guru on this – is that presidential elections depend, not on the state of the economy, but on whether things are getting better or worse in the year or so before the election. . . . . . .

    Put these two observations together – and what you get is that the tax-cut deal makes Obama’s reelection less likely. . . . .

    Think about the dynamics that sets up for December 2011. The Democratic parts of the deal will be on the verge of expiring, while the Republican parts will have another year to run. Won’t that put the Dems in a desperate position? Won’t Obama be strongly tempted to make further big concessions to get something to boost the economy for another year?

    • TMC on 12/09/2010 at 17:34

    Just came across CNN

    Defying President Obama, House Democrats vote not to bring up tax deal he

    negotiated with GOP in its current form.

    The Democrats are sending Obama a message. Don’t negotiate with terrorists

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