Course correcting for economic growth and real fiscal responsibility.

What should an overly indebted developed country government do to spur economic activity and reduce deficits and debt? Should they spend more, or less? Should taxes be increased, or lowered? A number of studies collectively suggest that government stimulus spending provides no stimulus at all beyond the original dollar amount spent. And where there are large deficits, spending should be cut. However, the best way to stimulate the economy is through lower taxes—and especially lower corporate taxes!

Increased government spending, say numerous economists trained in traditional Keynesian economic theory, should have a ‘multiplier’ effect that increases overall economic activity by an amount larger than the sum spent. However, some recent empirical research disputes that assumption.

In a prestigious US National Bureau of Economic Research (NBER) study, Identifying Government Spending Shocks: It’s All in the Timing, by Valerie A. Ramey, published in October 2009, she found that, "… none of my results indicate that government spending has multiplier effects beyond its direct effect." That is a dollar of government spending contributes only about a dollar to economic activity. In short, no multiplier effect exists.

Furthermore, the same conclusion was noted by Harvard University’s Economics Professor Greg Mankiw while reviewing new research in his blog post, "Spending and Tax Multipliers" on December 11, 2008. He stated "…Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar."

So, these studies indicate that increasing government spending does not increase economic activity by anything more than the original sum spent.

By contrast, cutting taxes seem have a much larger economic multiplier effect. Quoting Professor Mankiw again, he says, "…research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars…" (Incidentally, Christina Romer was chairman of President Obama’s Council of Economic Advisers in 2009-2010.)

One hypothesis is that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favorable to capital investment–a mechanism absent in the textbook Keynesian model."

Reviewing the spend and tax empirical data for most developed countries suffering from large deficits and debt is this study, Large Changes in Fiscal Policy: Taxes Versus Spending, by Alberto F. Alesina and Silvia Ardagna—another NBER paper, dated October 2009. They state, "we examine the evidence… of fiscal stimuli [stimulus] and in… fiscal adjustments [reducing deficits] in OECD countries from 1970 to 2007. Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

That dizzying paragraph was much harder for me to write than it was for you to read, but in easy speak; cutting spending is the better path from debt than tax increases. In fact, after reading the earlier statement from the Romer research, spending cuts need to be accompanied by tax cuts of approximately 1/3 the size to stay GDP neutral. This means that for every billion in spending cuts, a tax cut of 333 million should be allowed to counterbalance the negative effect on the economy.

Now, if cutting taxes gives the best boost to economic activity, are there particular taxes to cut that provide the most economic stimulus? The answer is yes, according to the OECD study, Tax Policy Reform and Economic Growth, November 3, 2010. The reviewers say that, "…corporate taxes are the most harmful type of tax for economic growth, followed by personal income taxes and then consumption taxes, with recurrent taxes on immovable property being the least harmful tax."

Corroborating these findings is another recent peer-reviewed study supporting lower corporate taxes: The Effect of Corporate Taxes on Investment and Entrepreneurship, published in the American Economic Journal in July 2010, stated "in a cross-section of countries, our estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI [foreign direct investment], and entrepreneurial activity… The results are robust to the inclusion of many controls." (The authors were from the World Bank: Simeon Djankov, Caralee McLiesh and Rita Ramalho. And from Harvard University: Tim Ganser and Andrei Shleifer.)

Based on this evidence, some observers argue to significantly reduce or even eliminate corporate taxes entirely! In fact, many countries and jurisdictions are reducing corporate taxes significantly, exactly because of such studies. Though no country has yet eliminated them altogether.

Most of these respected studies variously infer that one optimal solution to spur economic growth in developed countries is to cut taxes, while to reduce onerous government deficits and debt, Alberto F. Alesina and Silvia Ardagna suggest cutting spending. Moreover, some of these studies clearly demonstrate that to promote economic growth, governments should most especially cut corporate taxes.

Currently we have yearly deficits averaging 1.5 trillion dollars. Sure, it wouldn't be quite so bad if the economy was growing and more revenue was coming in, so lets deal with 2/3 of that and see what happens. We need a plan that works spending down 1.5 trillion dollars, while simultaneously cutting taxes by 500 billion dollars to counter the adverse effects that less government spending would bring. The tax cuts need to be primarily from the corporate tax source, but some room should be allowed for income tax simplification reform suggested in the Ryan plan, and further temporary payroll tax relief.

Making income taxes flatter, fairer, and much more simplistic, without the multitude of exceptions, deductions and credits, is still of paramount importance to make the act of taxation more efficient. But we are well overdue for a tax climate change for businesses that compete on a global scale. Both tax issues are critical to correcting the liberal Keynesian course the Obama administration has set.

My personal favorite plan is one that eliminates the corporate tax entirely, and replaces it with a 5% sales tax. For reasons I will never understand, a sales tax has not yet achieved the widespread acceptance it deserves. It completely removes business tax lobbyists from existence. It takes government intrusion and manipulation off of the business spreadsheet. Crony Capitalism would be dead! It's not like businesses ever paid their taxes from their profits. Their taxes were treated no different from any other business expense, worked into the price of the goods and services you, the customer, pays. It's what the "Fair tax" and "9-9-9" supporters refer to as a hidden tax. As such, the reduction of corporate taxes would result in lowering the cost of domestic products and services to the point where, even after the sales tax was factored in, the final price to the consumer would be less. Much like the income tax, corporate taxes have a multitude of tax deductions and credits that also introduce inefficiencies and inequalities into the act of taxation. A sales tax is clear-cut. No exemptions, no complexities, no gaming the system.

Although to a lesser degree, we will have to embark on the same road to fiscal responsibility that the Europeans are attempting to travel. Hopefully, we will have the intelligence to navigate that path with a more accurate map that allows us to avoid the pitfalls that would slow our pace, and prolong our journey.