Are All Tax Cuts Welfare-Enhancing?

July 16, 2009

Under the traditional framework of rational self-interested economic actors with no externalities and no administrative costs of tax changes, all tax cuts would be beneficial if we ignore the fact that there must be some financing mechanism (i.e. tax hike elsewhere or spending cut). Obviously different tax cuts would have a greater welfare increase than others (marginal rate cuts likely better than lump-sum tax cuts, ceteris paribus), but all tax cuts would have a net welfare gain.

Continuing to ignore the financing mechanism (assuming its zero), a tax cut by itself would be beneficial assuming that its value is greater than any combined loss stemming from irrationality that is induced by the tax cut, administrative costs of the tax cut, and any externality created by the tax cut. It’s also possible that a tax cut could produce gains from inducing irrational behavior to become rational, promote a positive externality or reduce administrative costs. Either way, we end up with a net welfare change amount (call this Wt) from the tax cut by itself (ignoring the financing mechanism). If this net welfare change is negative (i.e. Wt < 0), the tax cut should definitely not take place. If it’s positive (which is typically the case), then we continue to the second test.

Assuming Wt > 0, then the obvious next question is how the tax cut will be financed. And this leads us to the public choice question of what is the most likely welfare cost of the funding mechanism, label that Ct? If some wasteful government spending is likely to be foregone as a result of the tax cut, then it’s pretty much guaranteed that Wt > Ct. If Ct is negative (which is possible if that spending hurts society by itself) then again, Wt will assuredly exceed Ct. But because policymakers are imperfect, they aren’t likely to get rid of the most wasteful government spending in response to a tax cut, and they’ll get rid of something else. They could even end up raising some other tax to finance the tax cuts. Therefore, there is no guarantee that Wt > Ct, and the less Wt is (i.e. the worse the tax cut is relative to other tax cut alternatives), the more likely it is the case that Ct > Wt. (Even if the financing mechanism is deficits, eventually a deficit is paid for by either a tax increase or spending reductions, although this also leads to the issue of the welfare implications of inter-generational transfers).

In summary, tax cuts themselves have two main costs that they compete against. One is any costs that reduce the welfare gain from the tax cut itself (like tax-induced irrationality or administrative costs of the tax cuts). The second costs that tax cuts compete against are the value of what is foregone to finance them, and given the political hand that we are dealt, too often tax cuts may be up against something that actually has value like lower marginal tax rates. Not every tax cut is going to lead to reductions in the number of bridges to nowhere.



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