Tax cuts are not a panacea to broad based economic growth and well being. If you read through the below, try to remember my original point was changes in tax policy and their outcomes are subject to the conditions in which they are implemented.
- If taxes on the wealthy are cut with no change in fiscal expenditures, the net result is that the wealthy pay a smaller share of total expenditures, so—with the tax cut—wealth is effectively transferred from average households to wealthy ones.
- Because the richer the household, the smaller the consumption share of income, the net impact of such a transfer is that overall consumption declines, along with the consumption share of GDP. As the consumption share of GDP declines, by definition, the savings share must rise.
- But total savings need not rise. Here is one of the great confusions that tends to mar nearly every discussion about the impact of tax cuts on the wealthy. A decline in consumption will only be accompanied by an increase in savings if GDP remains constant, but GDP will only remain constant if a decline in consumption is matched dollar for dollar with an increase in investment. Total savings only rise, in other words, if total investment rises.
- Will investment rise? It turns out that if desired investment exceeds actual investment, the additional savings will be borrowed and invested, and investment will rise by the same amount by which consumption declines. The net effect is to convert consumption demand into investment demand, so total demand is unchanged. There is consequently no reduction in current GDP, which means that savings rise.
- As consumption is transferred into investment, current living standards decline for ordinary households, but future living standards rise as the greater investment leads to faster productivity growth. At first, ordinary and poor households are worse off and wealthy households are better off, in other words, but as the benefits of higher investment are realized, wealth trickles down to ordinary and poor households so all are better off.
- But this isn’t necessarily what happens. If desired investment is in line with actual investment, the existence of a higher ex ante level of savings will not increase investment because businesses have already invested all they want to invest. If that is the case, investment will not rise, except temporarily in the form of unwanted investment as inventory rises (lower consumption leaves goods unsold, which makes it seem at first as if point number 4 above is occurring).
- This means that consumption demand is not converted into investment demand (except perhaps temporarily), and total demand declines, bringing GDP down along with the decline in total demand. Although there is a decline in consumption, in other words, there is no commensurate increase in savings.
- But the rich do save more than the poor, so how is it possible that there is no increase in total savings if there is a transfer of wealth from average households to wealthy ones? The savings of the wealthy have definitely gone up.
- But total savings don’t rise because something must happen to reduce savings elsewhere. As consumption declines, those who produce consumer goods and services must cut back, and as they do so, they must fire workers. These workers shift from zero or positive savings to negative savings, so that the reduced savings of the newly unemployed counter the increased savings of the rich.
- There are three things that may temporarily interfere with this process. First, as consumption drops, and before businesses that produce consumer goods and services cut back and fire workers, they will see inventory rise or profits decline. Rising inventories cause (unwanted) investment to rise so at first it seems as if points number 4 and number 6 have taken place. But as declining profits reduce business savings, these will counter the rise in the savings of the rich.
- Second, the additional wealth of the rich pours into real estate markets and sets off a speculative real estate boom. This causes a rise in real estate development. In such a case, investment rises temporarily along with debt and at first it seems again as if point number 4 has occurred.
- Third, the additional wealth of the rich pours into the banking system and banks respond by lowering lending rates and relaxing lending standards. Riskier or more optimistic households that had previously been unable to borrow for consumption are now able to do so, and so consumption does not decline even as money is transferred from average households to wealthy ones. In that case, total demand is unchanged. There is consequently no reduction in GDP, which means that the savings of the rich rise as the savings of the ordinary and poor decline, and GDP is maintained by a rise in debt.
- To summarize, if desired investment exceeds actual investment, transfers from ordinary and poor households to wealthy households will immediately cause investment to rise at the expense of consumption, as living standards drop. But the overall economy will increase its total production of goods and services and, depending on how future higher income is distributed, ordinary and poor households will eventually see their income and consumption rise.
- If desired investment is in line with actual investment, however, investment will not rise sustainably. At first, either overall consumption will not drop because a rise in debt-fueled consumption will counter the drop in disposable income among ordinary and poor households, or overall investment will rise because of a temporary increase in unproductive investment—that is, unwanted inventory or excess real estate development—either of which also implies a rise in debt. Eventually, however, unemployment will rise, in such a way that as consumption drops, it is not replaced by higher investment but rather is accommodated by lower GDP. Overall savings will remain unchanged because the higher savings of the wealthy will be matched by the lower savings of the unemployed