Wednesday, March 13, 2019

Tax Cuts did boost GDP, so what?

Trump's tax cuts directly led to an increase in consumption. We can use many methods to help look at a countries growth such as using a Solow or DSGE model, but at the most basic level, growth, in the form of GDP is calculated by the addition of consumption, investments, net exports and government expenditure. A tax cut, putting more money in peoples pockets, directly leads to an increase in consumption which will increase the GDP. However, that DOES NOT MATTER. As an individual variable, consumption only accounts for short-term growth. In fact, it can even slow down an economy in the long term which I'll get into later. Investments and Trade are the sources of long term growth.

So why?

In the short run, how much stuff is made largely depends on demand - if stores sell all their goods they put on more workers and have people work overtime trying to get more sales.
But not all businesses can do that at once for long. Eventually workers become scarce, wages rise and businesses find it's no longer profitable to keep producing so much and the boom ends.

In the long run, the amount of stuff we can make depends on how clever we are, how good our technology is and how much capital (tools, machines and buildings) we have. Investment (depending on how you define it) creates these things, increasing how much stuff society can make without having to work overtime.

Tax cuts (that are not immediately financed by equal spending cuts), will likely lead to slower economic growth in the long term. Simple GDP accounting implies that holding all other things constant, tax cuts will result in an increased government budget deficit, which will reduce national saving and raise interest rates. This will crowd out private investment and, in the long-term, reduce economic growth. Why is this the case? Government budget deficits are financed by borrowing (through sale of government bonds). Additional government borrowing reduces the supply of loanable funds available in the financial system. This will raise interest rates, and reduce private investment.

In the short run, tax cuts increase demand and increase GDP in the short run (especially if the economy is in a recession).

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