President Donald Trump proposed last month a tax plan that would lower the top individual tax rate to 35% from 39.6%. It would also lower the corporate income tax rate to 20% from 35%.
The plan however, says nothing about how spending will be cut to avoid increasing deficits. According to supply-side economics — a relatively new school of economics — a reduction of tax rates and lower revenues for the government does not need to be offset by decreased government spending or increased borrowings.
It is held that the boost in consumer spending and investment in capital goods will set the platform for a stronger economic growth, which in turn will lift government revenues and trim the budget deficit.
Effective tax depends on the size of the government outlays
The problem rests with the fact that the government is not a wealth generating entity as such — the more it spends, the more resources it has to take from wealth generators. What really counts is the amount of wealth diverted to government from wealth generators.
Irrespective of the official lowering of tax rates, as long as government spending is not curtailed, there is not going to be an effective lowering of the government tax.
The government will always find ways to divert real wealth to itself. This could be achieved by means of printing money, increasing borrowings, or by imposing various levies. In the presence of a central bank, a lowering of tax rates — sans spending cuts — merely rearranges the way government diverts weath to itself.
So what then are we to make out of President Trump’s plan of lowering tax rates?
It is quite likely that the initial response of consumers and businesses to the lower tax rates would be to boost their spending.
However, without a real cut in spending, the impression that market participants now have more wealth is illusory. This results in the misallocation of resources.
Without the lowering in effective tax rates — achieved by lowering both spending and taxation — individuals would not lift their spending without the preceding increase in real wealth. What we have here is that more important market-guided priorities are denied the necessary funding in favor of government-spending activities that continue in spite of “tax cuts.”
This in turn means that the government’s faux lowering of taxes inflicts damage to the wealth generation process and curtails the potential economic growth.
No doubt — in terms of GDP — the lowering of the tax rates will appear to be a temporary success. This supposed success is likely because the increase in the money supply growth rate — which has a direct link to the so-called GDP growth rate — emerges to help the government to divert wealth to itself from wealth producers.
Note that real GDP is the amount of monetary expenditure on final goods and services — including government outlays — deflated by a dubious price deflator. Obviously, the stronger the monetary growth, the stronger the GDP growth rate.
We can conclude that a meaningful lowering of taxes can only emerge once the government has lowered its outlays in absolute terms. Once outlays are curtailed this will result in less wealth being diverted from wealth generators to the government.
Once more real wealth is made available to wealth producers, this strengthens the process of real wealth generation and sets the platform for stronger economic growth.
Contrary to what the followers of supply-side economics claim, it is not possible to strengthen economic growth by lowering the tax rates whilst keeping the size of government outlays intact.
What the followers of this type of economics suggest is that something can be created out of nothing. These followers confuse the GDP growth rate with the growth rate of the pool of real wealth.