One of the many appealing things that Donald Trump said to American voters in the run up to the Presidential election was a promise to not only simplify but also cut tax rates for lower and middle income American households. He also proposed to raise the minimum taxable income level, which would effectively exempt millions of poor Americans from paying income tax. While many have wondered how this is possible without the US Government incurring a sizable budget deficit, the argument put forth by Trump’s economic advisers rests on the principles of supply side economics.
Say’s Law states that “supply creates its own demand”. Understanding this is made simple if one considers a hypothetical one-commodity world, where a commodity X is the only good both produced and consumed by the economy. If the producers of X make a decision to raise the supply of X in the market, they would need to produce more of X. This would necessitate the hiring of more workers, or an increase in the number of labor hours from existing workers. In either situation, the total amount of wages given out would increase, which would imply a greater income in the hands of households. Greater purchasing power would in turn lead to a greater consumption demand for X, thus proving Say’s statement about supply creating its own demand.
When applied to Donald Trump’s proposed taxation policy, the principle of supply side economics is very similar. Tax cuts to middle and lower income class groups would put more take-home salaries in the pockets of these people, which would in turn lead to greater expenditure by households on commodities. Commodity supply and production would therefore need to rise to meet this excess demand, which would only be possible through the hiring of more workers, thereby creating greater employment opportunities and also giving the GDP a massive boost.
Moreover, the reduction in the tax rate would actually be offset by a greater tax base, i.e. while everyone would technically pay lower individual tax rates, there would now theoretically be more people paying tax in the first place due to the increased employment level. Hence, the tax cut would essentially pay for itself, and the Government would suffer no considerable loss in tax revenue.
As neat and tidy as this sounds, however, a majority of economists believe that supply side taxation theories simply don’t work, with many referring to such theories as ‘voodoo economics’. In particular, critics point out that the ‘trickle down effect’ of additional take home income inducing additional consumption is not nearly as powerful as supply side economists would like to believe. Statistical data shows that for every $1 cut in tax rates, only 17 cents is recovered in the form of induced additional consumption – not nearly enough for the tax cut to pay for itself.
While Trump supporters point to historical data during the Reagan-era administration when similar supply side theories were invoked, critics have argued that tax cuts only work when tax rates are already prohibitively high, as they were during Reagan’s presidency. In that case, the tax cut worked (to an extent) because rates were slashed from 70% to 28%.
Moreover, given that the Trump administration has announced plans to cut tax rates without any plans to reduce Government spending, and the economics behind the theorized rise in Government revenue is shaky at best, many feel that the budget deficit could double, much as it did towards the end of Reagan’s term. Critics argue that if the Government’s main aim is to increase the number of jobs and the overall employment level, the most effective tool to do so would be a reformatory monetary policy in the form of an expansion in money supply so as to make more liquidity available for businesses to invest.
Supporters of Trump’s economic plan, however, are adamant about its effectiveness. Some claim that while only 17 cents are recovered to the dollar in the form of consumption, the remainder will find itself in savings accounts in banks across the country – allowing these banks to mobilize these savings and invest them into small and medium scale businesses and start-ups, giving the economy an indirect reinfusion. Moreover, they argue that the proposed cut in the corporate tax rate by Trump will make the USA a more attractive location for multinational corporations to do business. These MNCs will no longer have any reason to shift their headquarters overseas, and will bring in much-needed FDI, which Trump’s advisers theorize to be to the tune of $3 trillion.
While Trump supporters cite historical evidence and rely heavily on data that similar tax cuts during the Reagan administration resulted in the creation of 16 million jobs, critics are far from swayed. Many economists have pointed out that the Reagan-era job creation was not because of tax cuts, but because of simultaneously coinciding historically low interest rates, which made it much cheaper to invest and grow in the 1980’s. Critics of Trump’s plans also present historical counter evidence: President Bill Clinton significantly raised taxes during his term, and yet enjoyed bigger job gains than Reagan (22 million compared to Reagan’s 16 million).
Hence, it was obviously not the tax cuts which were the driving force behind the Reagan-era employment surge. Many detractors of Trump’s scheme also point to the likely impending budgetary disaster a tax cut would cause, especially since Trump actually plans to increase spending, both on defense and on a massive proposed infrastructure construction program to “fix (their) inner cities and rebuild highways, bridges, tunnels, airports, schools and hospitals”, in Trump’s own words.
Trump supporters, however, once again fall back on supply side arguments, claiming that the proposed program would give millions of people jobs, but they turn a deaf ear to claims that such jobs, if created at all, would for the most part be low-paying manual labour jobs, the income on which would in any case not be large enough to be taxed under Trump’s scheme. Moreover, another major concern is that with the tightening of policies regarding immigration, there might not be enough highly-skilled engineers and infrastructural specialists to occupy all the new jobs Trump claims he will create.
Whatever be the outcome, only time will tell. The question now is whether Donald Trump will be able to keep all the many promises he made to the American public to get himself into the Oval Office, and juggle the economy and the country’s expectations while he’s at it.
-Contributed by Prithviraj