Tax, schmax. Nobody likes paying taxes: from the richest to the poorest, we all think we’re getting a poor return, even if we believe in theory, as me and Warren Buffet do, that taxes are a necessary evil for the good of society.
Given that I’d rather write a dinner invitation to my mistress’s mother-in-law than a bigger cheque to the Inland Revenue, I must be thrilled then at Gordon Brown’s plans to alleviate the imminent recession by cutting taxes, right?
Well, it’s hard for me to type these words, but… on balance… no.
Tax cuts would be good for me, but I don’t think they’re the best thing for this country. And as a long-term investor in (and citizen of) the UK, I’d rather see Brown spending to help the nation rather than my bank balance.
Cutting taxes helps us individually, but it might not help Great Britain PLC
It would take a very long post to discuss whether tax cuts stimulate the economy in normal times (so read that link from Investopedia, then pop back, if you like). But these aren’t normal times – house prices are plunging, we’re still in the grip of a credit crunch, and a recession is on the way.
Advocates argue cutting taxes will get more money moving through the economy, provided they’re not paid for by a corresponding cut in public spending. (The latter is something David Cameron doesn’t seem to grasp in his own proposals, incidentally).
But while reducing taxes and running up Government debt isn’t the worst way to respond to a recession (increasing taxes while running up debt is worse, for instance), I don’t believe it’s the best way to respond, either.
Of course I’m just a mere amateur investor, and Gordon Brown doesn’t read Monevator, as far as I’m aware (even though he nationalised Northern Rock just after I suggested he should. Coincidence? Fair cop.)
If you are reading, Gordon, I’d humbly ask you to consider what people will actually spend their extra tax-rebated income on:
- If you’re poor, you need all the help you can get to pay for costlier food and fuel – the alternative is debt or going without. Good for the poor, then – and they’re the best target for tax cuts in terms of getting spending going – but not spectacular in terms of usefully growing the economy.
- In my case I’ll immediately boost my savings. Most middle-class people will do the same, or pay down their mortgages. I won’t spend a penny of the extra tax on a new fridge, an extra haircut, or any of the other things that could help revive the economy (short of my savings shoring up my bank’s balance sheet, and the Government has already bailed out the banks with our money once).
- Other people will use their extra income to pay down debt. While getting out of debt should be the number one priority for any individual, it’s exactly what the Government doesn’t need us to do as a nation. The UK economy needs us to spend, spend, spend, even though that’s partly what got us into this mess in the first place.
When saving is bad, and spending is good
This strange state of affairs – that the Government needs us to spend in the face of the downturn, but that individually we’re better off saving – is known as the Paradox of Thrift.
The paradox was popularly defined by the great and suddenly popular British economist John Maynard Keynes. In simple-ish terms:
In equilibrium, total income (and thus demand) must equal total output, and total investment must equal total saving. Assuming that saving rises faster as a function of income than the relationship between investment and output, an increase in the marginal propensity to save, all other things being equal, will move the equilibrium point at which income equals output and investment equals savings to lower values.
Okay, sorry, that wasn’t much simpler was it?!
Let’s try it again in probably too simple terms (with my apologies to any economists reading):
The paradox of thrift is that saving is only a good thing for society up to a point. If you or I spend less of our money on plasma TVs or hot dogs and save more instead, we lower the total demand in the economy. Saving is only good for the wider economy in so much as businesses will use our savings to invest in new economic activity. Saving beyond that will actually increase the pain of a recession, by effectively taking money out of circulation.
The paradox of thrift is one of many things that afflicted Japan in its ‘lost decade’. Scared by Japan’s huge stock market and property crashes, its people began to save too much of their income for the good of the Japanese economy, and as a result it dipped in and out of recession for years.
Why we should build roads, railways, and factories instead
If Gordon Brown was a proper follower of John Maynard Keynes, he’d be investing more in infrastructure instead of cutting taxes.
Upgrading the UK’s railways, roads and airports, for example, would provide thousands of jobs right now, when they’re needed, and so trickle money out into the wider economy, as well as eventually increasing Britain’s economic competitiveness against other nations.
Of course, we’d still have to pay for all these shiny new projects in the future – Government borrowing would rise, and would one day need to be repaid. But we’d hopefully all be a little richer on the other side of the recession, because Britain would be doing a little more business because of the investment we’d make today, so the pain of those tax increases would be lessened.
On that note, yet another argument against tax cuts is that they don’t work because people understand they won’t last, and so save more to pay for tax rises in the future. Again, people have based careers on arguing out this stuff, but it’s another point to consider.
A more immediate problem is that the bond market will be well aware that the Government is freely spending.
If bond investors believe that Gordon Brown has lost control over public spending, long-term bond rates will likely rise, increasing the cost of borrowing for businesses and for our own fixed rate mortgages. This would actually drain money out of the economy, making matters even worse.
Tax cuts are better for boosting votes than the economy
Despite his 10 years at the Treasury, Gordon Brown has repeatedly proved he’s weirdly immune to the (so-called) laws of economics.
This is the man who claimed he’d presided over an “end to boom and bust”, remember, despite centuries of economic history suggesting otherwise.
Why then does he want to cut taxes rather than spend? Could it be because infrastructural investment looks like (and often is) wasteful Government largesse, but that tax cuts look like the actions of a Government worth voting for? Surely not!
If Brown does cut income taxes for all, then sadly I’ll be increasing my savings to prepare for tax rises in the future, and for any higher mortgage rates. My country may need me to spend, but I’m no more a financial kamikaze artist than the modern day Japanese.
If you’ve just started to take action in the face of the downturn, you might get some ideas from my four tips to surviving the credit crunch. If you’ve already taken cover, try these advanced anti-credit crunch goals.
