Shanghai American School Economics Student Blog » You Hate Taxes, I Hate Taxes… Let’s Hug- by Alice Su

I’m repeatedly amazed at the intelligence and maturity of the young economists here at Shanghai American School. After only nine months of econ instruction, these students already know more about sound economic policy than politicians of 40 years! Case in point: SAS senior Alice Su offers an stinging critique of John McCain’s proposed tax plan over at the SAS Economists Blog. Read below…

It’s easy to see how politics and sound economic policy may not mix very well; in fact, trying to put the two together usually ends up in contradiction and confusion that puts economically concerned voters in great distress. (Example: Remember that one econ class when Welker was talking about taxes, trying to decide if he was more liberal or conservative, and then got so agitated that Jeff said “You’re having a midlife crisis” and Welker threw a smartboard marker at him yelling “I’M 29!!”? Case in point. :P)

In this case, McCain’s speech about his economic policies on Tuesday contains so many contradictions, both with classroom economic theory and various parts of his own policy platform, that I find myself questioning whether he is taking a solid stance on the economy at all, or is simply trying to say whatever will appeal to his audience the most.

First, McCain’s economic plan, dripping with supply-side sentiment, is centered around a series of tax cuts. In addition to making Bush’s tax cuts permanent, he also calls for cutting corporate taxes, phasing out the alternative minimum tax, doubling the value of exemptions for each dependent to $7,000 from $3,500, and giving people the option of using a simpler, shorter tax form. As a finishing tax-cut touch,

One of Mr. McCain’s tax proposals would take effect even before the Republican Convention: he called on Congress to suspend the 18.4 cent a gallon federal gas tax from Memorial Day until Labor Day. Mr. McCain said that doing so would provide “an immediate economic stimulus,” but some environmentalists said that the change might encourage more people to use their cars, while Mr. McCain has made combating global warming central to his campaign.

Hmm. Here’s where the first hints of contradiction kick in. Besides the conflict between wanting to end global warming and yet encouraging more cars on the road, we’ve all studied the Laffer Curve, and I think I can speak for all the SAS Economists when I say that the U.S. Economy is not at a place where further tax cuts will lead to an increase in tax revenue or benefit the economy. Furthermore, what about the enormous budget deficit that Mr. Bush has so graciously left us with? As the author of this article discreetly points out, McCain seems to have forgotten that he previously promised to balance the budget by the end of the first term; rather than offer the economic stimulus that McCain is claiming it will, the tax cuts would probably just plunge the nation deeper into debt.

What answers do McCain’s economic policy have to offer these questions? Well, he also proposes a one-year freeze on most “increases in discretionary spending” while he reviews every federal program, department, and agency… with the exception of spending on the military. Supposedly, the money saved from eliminating earmarks as well as getting rid of unnecessary “discretionary spending” will add up to $100 billion annually, and that is how McCain says he will pay for the lowered business taxes. However, he neglected to address the issue of all the money being spent on the wars in Iraq and Afghanistan, and whether any of that might be categorized as unnecessary “discretionary spending”, or whether we should be spending anything over there in the first place.

An analysis by the Center for American Progress Action Fund, a liberal think tank, estimated that the overall cost of Mr. McCain’s tax cuts would be three times as much as the $100 billion he estimates that he can save. And they questioned whether his programs would really save $100 billion a year.

While I’m not saying anything in support of Obama or Clinton’s economic policies, McCain’s plan seems so shaky that I would think twice before buying into how he’s going to save our country. Personally- especially since this tax-cut-focused speech was given on the day of the deadline for filing taxes- it looks to me like another plan designed for the purpose of politics, and not with sound economic policy in mind.

Wednesday’s class this week was one of my favorite of the year. Why? We got to talk taxes. Oh my goodness, you say, what’s wrong with Welker? How could he actually enjoy talking about taxes? As I said at the beginning of class, there are only two certainties in life: death and taxes.

For most people, taxes are a dismal subject, to say the least. But for teachers of economics, especially in this presidential election year, taxes make for an exciting economic, political and philosophical debate.

The premise of our discussion in class was the idea put forth by Arthur Laffer nearly 30 years ago towards the beginning of the Regan administration: that if the government would cut taxes on businesses and households, the incentive to invest and work would increase so much that gains in total output and income would be such that the government’s tax revenue might actually increase, despite the tax cut! Cutting taxes on the wealthy would have the greatest positive effect, however, since it’s the wealthy who do most of the investing and much of the spending in the economy.

This basic philosophy underpinned the tax cuts the wealthy enjoyed during Regan’s presidency, and again during George W. Bush’s term in 2001 and 2003. The debate about whether taxes cuts made by the current president is one at the heart of the Democratic/Republican divide today.

Watch the videos below, then answer the questions that follow:

First, the Democratic view:

Then the Republican view:

Discussion questions:

1. Why do Obama and Clinton promise that if they’re elected we’ll “go back to the tax rates we had before President Bush”?
2. What is McCain’s criticism of Obama’s view on taxes?
3. What do you think about the “supply-side” argument that lower taxes will stimulate spending, growth, employment, and possibly even the amount of tax revenue collected by the government? Do you buy it?
4. Are you a “supply-sider” or more of a Keynesian when it comes to the role of government in the economy? What’s the difference?

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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A short walk on the supply side | Free exchange | Economist.com

The Economist’s Free Exchange Blog wrote this timely piece on supply-side economics and the Laffer Curve. I couldn’t have (in fact, I didn’t) explained this better myself!

“The basic reasoning behind the so-called “Laffer curve” is plain, uncontroversial, and by no means was discovered by Arthur Laffer. There is nothing to tax if no one produces anything. But taxes affect the return and therefore the motive to supply labour to economic production. An increase in the tax rate can reduce the pool of wealth to tax — the tax base — by reducing the supply of labour. No taxes, no revenue. Also, 100 percent tax rates, no revenue. Somewhere in between — exactly where depends on, among other things, the responsiveness of labour supply to after-tax wages — there will be a point at which an increase in rates delivers a decrease in revenue. If the tax rate is already past that point, a tax cut delivers more revenue.

…labour supply is just one of many ways in which an increase in tax rates may reduce the effective tax base. In addition to working less, individuals may alter their savings and investment patterns, bargain to shift more of their labour compensation to untaxable perks and benefits, move to a different tax jurisdiction, consume more tax-deductible goods, or simply hide income from the tax authorities.”

As Laffer’s model shows, at certain tax rates, a tax cut will lead to an increase in tax revenue. So how can policy makers be sure whether a country’s tax rate is at such a level? In America, where relatively high income earners pay around 35% tax, economists calculate that a tax cut of 10% would increase taxable income due to more labor and greater productivity, but indeed decrease overall tax revenue.

Conclusions? “Supply-siders” who advocate tax cuts need to look more carefully at where America is on the Laffer curve.

Republican politicians of late have exhibited a dismaying lack of respect for basic science, and it is not much of a surprise that many are also cavalier about fiscal economics. At current tax rates, new cuts will not “pay for themselves” in the short run. Emphasizing this point, however, does not begin to imply that raising tax rates is smart or harmless.

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What McCain Could Do About Taxes - New York Times

McFlation?

John McCain admits that economics is not his strongest suit. He recently claimed that he  wished “interest rates were zero.” Perhaps the fallacy of this policy position is over his head, but I think there are at least 74 AP Econ students here in Shanghai who could explain to Mr. McCain the inflationary impact zero percent interest rates would have.

Regardless, the article above is not about interest rates (thankfully, interest rate and monetary policy decisions will never be his to make even if he does end up in the White House, granted Fed independence remains intact!), rather, tax policy, which would be within McCain’s powers as the designer of the US federal budget. Ben Stein, economist, actor, and humorist, writes a letter to Mr McCain offering his advice on tax policy. Continue Reading »