Many people believe that cutting taxes is a big contributor to economic growth. After all, it does make sense, doesn’t it? I mean you allow people to get more of their paycheck; they will have more to spend and put the money back into the economy. This is what our logical minds tell us, and this is what Economics 101 purports in our college and, in some cases, high school classes. However, does cutting taxes, in itself, produce growth in the overall economy?
Many people point to the Ronald Reagan years and cite “Reaganomics” as proof to supply-side economics. You give people tax breaks; they will spend more money, which will spur economic growth. As most people know, tax breaks usually benefit the wealthy the most. So, Reaganomics takes supply-side economics an extra step beyond and claim that there is a trickle-down effect…meaning if the wealthy gets to keep more of their money, then they will be able to hire more workers and build more homes, providing shelter for more families. Again logically, no one can dispute this. Yes, theoretically speaking, if the rich gets to keep more of their money, then they will be able to hire more people and provide more shelter.
Where our logic fails is what happens if we give people tax breaks, but they decide to sit on the money or they decide to put their money elsewhere because they see more growth in foreign and emerging markets, rather than in our very own country? Remember, the rich do not have the obligation to put their money back into our economy. I mean it would be very nice if they actually do what is expected of them. But if they do not, there is really nothing much we can do.
So, what really drives growth and investment? We have to take a look at the demand side of economics.
Until this day many people still tout Reaganomics, arguing that tax cuts was what created the colossal growth in our nation during the 1980’s. Reagan was actually really good for the economy. He created 16 million jobs. The stock market increased by leaps and bounds. The entertainment industry grew like it never grew before, and America was the envy of nations from around the world. But, was it really his tax cuts that drove the economy or was it something else?
If we look at this a little bit more closely and look at this phenomenon through the demand-side economics point of view, we can see that the proliferation of credit cards of the 80’s greatly drove consumer spending, which contributed significantly to US’s economic growth, at the time.
If you were young enough, you might have noticed all the credit card solicitations that were broadcasted over the airwaves, on our TV screens, in our junk mail, and posted on billboards all over the place, during the 1980’s. American Express, Diner’s Club, Visa, and MasterCard were everywhere. Credit cards were supposedly our best friends, at the time, because they provided instant gratification, and consumers were eating up credit like there was no tomorrow. You want that HiFi Stereo? No problem. Just whip out that credit card. You want that gorgeous outfit that fits you to the T? No problem. Do you have AMEX or MasterCard? Boy-o-boy, it’s like having your best friend paying for everything you desire!
Anyway, long story short, consumer credit drove most of the growth in the Reagan era … not so much the tax cuts. In fact, Reagan raised taxes during the end of his Presidency. If this does not convince you, then remember that George H.W. Bush and George W. Bush also followed the principles of trickle-down economics, and the economy grew dismally, with the slowest jobs creation in modern history.
Then we had Bill Clinton, who raised tax rates on the wealthy…including the middle-class. OMG! How dare he do that?!!! Yet, the economic grew unbelievably well during his Presidency. How did this happen? Demand side economics, brother!
The investment in technology and the Information Super Highway created a totally new industry that transformed the way we live and do business every day. Just think about it. We all use the Internet nowadays. One day without the Internet at work feels like we are handicapped for weeks. The Internet created jobs, which led to higher consumption, therefore a greater economy.
We needed computers to access the Internet. So, people were buying computers. Computers needed software for operational purposes, so computer software companies were popping up all over the place. All of this led to ecommerce, a different way of doing business, which led to more innovation and a new way of competing in the market place. Ecommerce created new businesses. Young people were becoming entrepreneurs and had to buy equipment and rent office space for their companies. This led to more investment and higher growth. This cycle goes on continually at a very rapid pace.
Of course, economies that grow too rapidly will overheat and eventually cool down…which is what happened with the dot-com bubble. But, that is beside the point. The main take-away is that demand is what drives the economy. Create the demand (by building and investing in a new and upcoming industry), and tax cuts would be trivial to economic growth. The question is where do we generate the demand? This something that the people at the top, including ourselves, have to ponder upon … instead of just thinking about tax-cuts, all the time.