How Certain “Spending Cuts” Can Have Similar Effects as “Tax Increases”

August 25, 2009

There are some in Washington who take the simple view that any tax cut is good and any spending cut is good. But that’s bad economics for a variety of reasons. Case in point from a supply-side perspective: Suppose government decided to cut spending by means-testing Social Security for high-income individuals based upon their AGI levels (i.e. gradual phase-out of Social Security benefits) and then used that money to double the child tax credit.

Under this scenario, tax revenues would fall and spending would fall, but economic welfare would actually decline because the phase-out of Social Security benefits would be an implicit tax on the incomes of high-income individuals that has a large deadweight loss whereas the child tax credit “tax cut” has little economic benefit (the economic effect is mostly similar to a lump-sum transfer).

This is similar to the case when minimum wage hikes are often lumped together with targeted tax credits on small businesses. Taken as a whole, the bill would actually lower taxes. But the economic harm of the implicit tax of the minimum wage would exceed the economic benefit of what are typically poorly-administered tax credits (ignoring distributional concerns).

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