Is Lowering of Taxes a Viable Alternative for Governments Today?

Improving Tax Design & Structure is the Solution, Not Lowering of Taxes

Lowering of taxes is one of the most populist proposals any government can make. The aversion of people to the word ‘tax’ makes every such proposal politically welcome. However, given the central role of taxes in our economies, and the role of taxpayers as the lender of the last resort, it is generally not possible for governments to go for it. What does happen quite often, though, is a sophisticated manipulation in design, invariably favouring those who have the means to lobby for it…

Demand for fiscal stimulus has always co-existed with similar demands for monetary stimulus, ever since the global economy took a dive following an economic crisis ten years back. While the governments and the central banks have been far more accommodating in acceding to the demand for quantitative easing, they have generally not obliged with fiscal relief. One of the main reasons for this dichotomy may lie in the fact that the costs of all economic packages are recovered finally through taxation. A relief in taxes will need another viable source for funding the damage control, and as of now, no such source seems to be available with the governments.

Thus, extending a fiscal stimulus can be virtually suicidal in an economy already ailing from a crisis.

Role of Taxes as the Lender of the Final Resort

The experience of the last decade has added one important dimension to our understanding of economic and financial risk management. Traditionally, banking is considered the most risky sector of the economy, and one that cannot be allowed to fail. The failure of even one bank can lead to spread of panic that can result in extensive “bank-runs” and bring down the financial sector. This is the reason why a Central Bank is expected to back-up all banks, whether public or private, as the lender of the last resort, so as to safeguard the integrity of the financial sector.

However, the central banks do not have any resources of their own. They can print money, but the real resources that back them up belong to the State, or to put it more accurately, to the taxpayers. Thus, all relief packages are eventually financed with taxpayer’s money. Taxes or the taxing rights of the State lie at the core of all supporting mechanisms to deal with economic crisis.

Role of Taxes in Economy

Taxes are sometimes referred to as the next most certain thing after death, and I might add, they may very well be the second most hated object as well. Yet, taxes are also the very lifeline of a state, very much like blood within our veins. So we need to be very careful when talking about reducing the amount of this blood flowing within the body of our national economy.

The two most important roles of taxes are to provide financing for the public goods and services, like national defence, law and order etc., and to allow some critical redistribution of resources from the better-off within the society to the least well-off. Both these purposes are critical for the health of a nation, and neither of them has any alternative method of sustainable financing. Hence, lowering taxes is bound to hurt one of these two functions. In simpler words, a lesser tax liability means higher private consumption, but it also means a weaker government, smaller defence capability, less resources for law enforcement, poorer infrastructure and sometimes lesser research. Worse, it may also mean more suffering for the poor.

Tax Reforms in Last Few Decades

While taxes are definitely purposeful and necessary, there could be certain circumstances, where they are excessive, and hence inefficient. Very high tax rates serve no purpose. They act as a disincentive for business and earning, constrict the economy itself and actually lower revenue collection for the government. Hence bringing down excessive levels leads to economic expansion, higher income and private consumption and greater revenue for the government at the same time. But once the tax rates are already brought down to appropriate levels, as is the case of many countries, any further tax cuts will not lead to the same results.

During the last few decades, rationalization of maximum marginal tax rates have actually helped improve the economy in several countries. Ironically, lowering tax rates did not reduce collections. This is generally explained by the phenomenon of ‘Laffer Curve’ being at work. But more recently, countries have also experienced different results. The fiscal deficit is rising in many countries, and higher consumption has lead most countries including the United States to have a large trade deficit. The expansionary fiscal policy followed by some Governments across the globe has only added to the problem.

Can Taxes be reduced Further?

The world is currently abuzz with the proposals made by Trump Administration to reduce corporate taxes to around 20%. This has led to mixed responses from different quarters, but the primary question on everybody’s mind is whether it is a feasible proposition. Can the US Government actually manage with a much lower rate of corporate tax. A consequent response would be that if it is possible for the United States to do so, should other governments also follow suit.

While looking at these questions, one needs to note the difference between the corporate tax rate between the United States and other countries. Most countries of the world have a corporate tax rate of 20 to 25%, whereas in the United Stated the maximum marginal tax rate was above 35%. Thus, a reduction by the United States may not necessarily be similar to a reduction elsewhere.

Another important dimension in any fiscal policy is the mix of taxes that go to make the government revenue. In the United States, personal income tax has traditionally been a major component of revenue, something that is not always true of other economies, particularly in the developing world. Personal income tax is traditionally progressive and hence one of the most equitable taxes. Its reduction would be more favourable to the rich rather than the poor.

Tax Policy is not easily understood, not even by economists. Taxes on dividends and capital gains are a burden on the richest, but in most countries, they have already been relieved to an extent that hurts the progressiveness of tax system and tilts the tax burden on the poor more than it is on the rich. The design and administration of property taxes and inheritance tax, the other two taxes that can help in redistributing resources, is even worse in most countries, and provides unfair relief to the rich over the poor.

Most monetary and fiscal relief packages to address economic downturns actually help the capital owners more than the workers, whereas that relief is financed by taxes on all, and the tax burden falls largely on the workers. Such changes can only end up making things worse for an ordinary income person. When the relief is given in progressive taxes, such relief is also taken up by the rich, while it is financed, either by other tax adjustments, or by inflation, or in some other way, eventually, by the masses in the relatively lower income groups.

Thus, any lowering of taxes is more than likely to end up as a burden on the poor, rather than the rich. At a time, when the global wealth is getting increasingly concentrated in the hands of a few percentiles at the top, it is hardly a viable preposition. To conclude, further tax reduction may help the richest, but if the burden of such relief is passed on to the masses, as is usually the case, it would be a poor policy change. 

Worse, it can lead to severe economic and political repercussions!