To Spend or to Save? - That is the Question
Subject Tax Cut
Topic Fiscal Policy
Key Words Supply-Side Economics, Efficiency, Economic Growth
News Story

President Bush's proposed tax cut plan has generated considerable discussion among economists. One group, following the same arguments put forth 20 years ago by President Reagan, favors tax cuts because they promote greater efficiency, while another group, identified with liberal economists, believes that the surplus should not be returned and should be devoted to pressing social needs. Whether the economy would be better off spending the surplus or returning it to the taxpayers will be debated more intensely in coming months.

President Regan proposed a substantial income tax cut about 20 years ago. Regan believed that the economy would benefit from cuts to marginal tax rates because it would provide incentives to workers to work harder with greater dedication and efficiency. President Bush has adopted this supply-side view with the additional argument that leaving the budget surplus in the hands of the government encourages Congress to spend it and therefore leads to wasteful government spending. Conservative economists also argue that increasing the rewards for entrepreneurial behavior through reductions in taxes encourages people to invest their money in riskier ventures. This promotes more rapid economic growth to the point where total tax revenues may increase even in the face of decreased marginal tax rates.

Opponents of the Bush tax cut proposal argue that the surplus is needed for important social and economic goals. Corporations and individuals holding mortgages would benefit if the surplus was used to buy down the debt. The repatriated debt could be put into other forms of savings like corporate bonds or stocks and companies could use these funds to invest in new technologies or increasing productivity through better training for its workers.

The Regan tax cut was followed by a significant upturn in the economy. Whether the upturn was the result of the tax cut, increased governmental spending, Federal Reserve policy or any and all of the above has yet to be decided. Even if the Regan tax cut did work, liberals argue that the Bush cut is too small and spread over too many years to have any impact on incentives and entrepreneurial activity.

(Updated April 1, 2001)

1. Draw an aggregate supply/aggregate demand diagram illustrating the economy at macroeconomic equilibrium with a recessionary gap.
2. What would happen to the economy if the government reduced its spending? What would happen if the government lowered taxes by an amount equal to the reduction in spending? Show these two results on your diagram.
3. What arguments are made by supply-side economists to support a tax cut. Illustrate the supply-side view on your diagram.
4. Is a tax cut an effective anti-recessionary tool? Evaluate the argument made by some economists that the tax cut is bound to be implemented too late to counter the economic slowdown.
5. What is a tax on capital gains.
Source Louis Uchitelle, "Economists Split: Public Spending vs. Private Savings," The New York Times, Febraury 10, 2001.

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