Earlier this month, the Finance Ministry hinted at the possibility of actually bringing down personal income-tax. As we all know, income-tax forms an important revenue source for governments of most countries.
So, does this proposed `tax cut' on personal income mean that the government will have less money to spend? Advocates of conservative economic orthodoxy would say that the government can ill afford to cut taxes when it already has its hands full with a variety of schemes, such as the National Rural Health Mission, the Sarva Shiksha Abhiyan, and so on.
The world over, the most popular argument against tax cuts, is that decreases in taxes would reduce future government spending. But a husband-and-wife team of economists at the University of California and Berkeley holds a different view.
Christina and David H. Romer's working paper Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending finds no support for the hypothesis that tax cuts restrain government spending; indeed, the couple suggests that tax cuts may actually increase spending.
"This idea that cutting taxes will lead to a reduction in government spending has become a staple of conservative economic orthodoxy," write the Romers in the National Bureau of Economic Research working paper (www.nber.org).
"Distinguished economists from Milton Friedman to Robert Barro have argued that the most effective way to shrink the size of government is to `starve the beast' by reducing tax revenues."
Effect of tax cuts
The Romers examine four episodes of major tax cuts and then reinforce their conclusions. "The relationship between revenues and spending is surely not independent of the causes of changes in revenues," they declare. "For example, if spending-driven tax changes are common, a regression of spending on revenues will almost certainly show a positive correlation.
But this relationship does not show that tax changes cause spending changes; causation, in fact, runs in the opposite direction." For the uninitiated, in statistics regression analysis is a technique that examines the relation of a dependent variable to specified independent variable(s). Basically, it allows to be used as a descriptive method of data analysis without relying on any assumptions about core processes generating the numbers.
The Romers use regression to find a causal relationship between revenues from taxes and government spending. To their amazement they find that not only was there no direct correlation between tax changes (cuts) and government spending but also that government expenditure rose after legislated tax cuts!
For instance, if automatic and legislated counter cyclical tax changes (here taxes are reduced because the economy is in a severe recession) are common, then one may look forward to see government expenditures rising after declines in revenue.
This is because probabilities of spending on unemployment insurance and other relief measures typically rise in bad economic times. In this case, "both revenues and spending are being driven by an omitted variable: the state of the economy," the authors state in the paper.
Therefore, looking at the comprehensive relationship between revenues and spending without accounting for the causes of revenue change may indicate biased estimates of the effect of revenue changes on spending. Bias naturally had to be removed. And was.
How they did it
The authors feel that legislated tax changes are categorised by motivation. And motivations were a key input into their tests of `starve the beast hypothesis'.
"It is important to describe our classification of motivation (the reason behind tax cuts) and to discuss which types of tax changes are likely to yield relatively unbiased estimates of the effects of tax changes on government spending." The Romers thought it would also be useful to provide a brief overview of their identification of the motivations for tax changes, and of findings about the patterns of legislated tax changes in the post-war era (of the US).
They broke up different types of tax changes into four distinct groups, as follows
First, changes motivated by counter-cyclical considerations. "These are changes made because policymakers believe that growth will be above or below normal, and therefore change taxes to try to keep growth at its normal, sustainable level."
Second, changes motivated by `contemporaneous' changes in spending. Very similar to policymakers of countries that strive to become a welfare state, here the taxes are supposed to pay for introduction of a new program or social benefit. Hence, the rise in taxes will pay for the new initiatives.
Third, changes made to reduce an inherited budget deficit. By definition, these changes are all hikes. The authors mention the 1993 Clinton tax increase, which was "undertaken not to finance a contemporaneous rise in spending, but to reduce a persistent deficit caused by past developments."
And fourth, changes intended to raise long-run growth. This is a broad segment that was perhaps consciously designed to capture changes that were not made to keep or return growth to normal, but also the ones, which were not explicitly for deficit reduction. It includes tax changes motivated by a range of factors.
Christina and David Romer conclude that the tax changes that are surely the most appropriate for testing the starve the beast hypothesis are those taken to spur long-run growth. The last type as mentioned above.
The reason for opting was simple. The behaviour of government spending following tax changes motivated by long-run considerations was taken because these tax changes are not motivated by factors that are likely to have an important direct effect on government spending, the authors reason.
They use a detailed examination of a wide range of policy documents, such as presidential speeches, the Economic Reports of the President, and the reports of the House Ways and Means Committee, to identify all significant legislated tax changes in the post-War era. This helped them to identify the motivation behind the tax cuts. "We then identified the motivations policymakers gave for each action. We find they are usually both quite explicit and remarkably unanimous in their stated reasons for undertaking tax actions," the researchers claim.
Armed with data on tax changes and expenditures through first quarter of 1957 till the last quarter of 2006, the authors examine the four episodes of major long-run tax cuts in the US.
What they found
"The one aspect of the episodes that is somewhat consistent with the hypothesis that tax cuts reduce government spending is the narrative record of the budget process."
The study shows that although the presidents in two of the episodes (Johnson and Sr. Bush) appeared to have paid little attention to the impact of the tax cuts on revenues in formulating their budget policies, the presidents in the other two (Truman and Reagan) cited the level of revenues as a consideration in forming budget policy.
"Even in these cases, however, other factors were clearly much more important, and to a considerable extent the concern over revenues led not to advocacy of spending reductions, but to support (or acceptance) of tax increases," the Romers think.
Thus, the actual behaviour of spending in all four episodes provides no support for the `starve the beast hypothesis'. In no episode was there a perceptible slowdown in spending following the tax cut. In fact, in all of the episodes, there was a stepping up of spending. This was similar to the overall statistical finding of a positive (though only marginally significant) effect of tax cuts on spending, and suggests that the regression results reflect a consistent pattern in the data rather than the effects of outliers.
By and large the paper addresses most important issues. However, as the authors concede, the result that spending does not fall in response to tax cuts raises an obvious question. "How does the government budget eventually balance?" One possibility is that what gives in response to a tax cut is not spending but the tax cut itself, they postulate.
They examine the response of both tax revenues and tax legislation to long-run tax cuts. The outcome is surprising. Revenues fell in response to a long-run tax cut in the short run, but then recovered after about two years. "Most of this recovery is due to the fact that a large part of a long-run tax cut is typically counteracted by legislated tax increases within the next several years," the economists conclude. Thus, it appears that in the wake of tax cuts, budget balance is restored mainly on the tax side rather than the spending side.
The research findings can make one wonder whether, in the Indian context, there can be cause for sustained rejoicing. For, if the government were to lower personal income tax rates, it just might neutralise the loss with small or barely noticeable hikes in the next few years, to sustain an unabated government spending.