The relationship between taxation and economic performance, like so many contemporary issues, invites controversy. Part of the problem is polarization within the field of economics. The schism -- often posed as a conflict between “freshwater” and “saltwater” economists -- reflects fundamentally divergent interpretations of existing evidence on the effect of taxation on productivity.
The “freshwater” economic perspective is so-called due to its formulation at Midwestern universities near the Great Lakes, and argues that most forms of taxation introduces inefficiency into economic relationships, and acts as a drag on economic performance.
The argument underlying the freshwater approach is that by incentivizing wealth acquisition, tax cuts and reduced regulation creates rapid economic growth. Where freshwater economists accept economic interventions by government, they generally follow the late Nobel Prize winning economist Milton Friedman’s argument that monetary policy -- referring to the use of the Federal Reserve’s control over lending rates to tighten or loosen the money supply circulating through the economy – is preferred.
On the other side, New Keynesian, “saltwater” economists trained at Harvard and Princeton believe governments can and should engage in economic interventions to mitigate the worst aspects of market failures. Drawing on the work of Depression-Era British economist John Maynard Keynes, saltwater economists believe fiscal policy, in the form of discretionary spending, can reduce recessionary contractions of the economy, and minimize the amounts of time workers remain unemployed.
From this perspective, the role of fiscal policy is metaphorically similar to what happens in an emergency room when medical workers are confronted with a gunshot victim: the first task in emergency medicine is to prevent a drop in blood pressure from causing the victim to go into shock and cardiac arrest, using intravenous fluids to replace lost blood. Maintaining liquidity plays a similar role in economics.
You do not need a formal education in economics to recognize that fiscal policy can significantly influence how the economy performs, and that some public policies can actually stimulate economic activity that the private marketplace usually will not undertake. A more realistic appraisal of this relationship begins by recognizing a few basic facts.
First, all forms of taxation impose a burden on the economy. As Supreme Court chief justice John Marshall asserted in his famous majority decision in McCulloch v. Maryland (1819), “The power to tax is the power to destroy.” However, balanced against that fact is Associate Justice Oliver Wendell Holmes’ equally important assertion, “Taxes are the price we pay for civilization.” These two statements, taken together, suggest a median perspective, facilitating recognition that at some level onerous taxation may inhibit economic productivity, while too little taxation that leaves the state incapable of providing the basic services that make a productive economy possible. However, not all government spending is equal burdensome, and some taxes facilitate fiscal expenditures that stimulate rather than inhibit economic activity. More on that in a moment.
Second, critics of fiscal profligacy – among them former Oklahoma Senator Tom Coburn – gleefully catalogue myriad instances of waste, fraud and abuse as a justification for massive cuts to the federal budget. However, the actual cases cited are microscopic when compared to the overall federal budget.
Tax critics point to pork barrel politics like the infamous “Bridge to Nowhere” in Alaska, but all too often omit adequate context. For example, critics of the Bridge to Nowhere – known to Alaskans as the Gravina Island Bridge project -- ignore the extent to which lack of roads has retarded Alaska’s economic development. Federal subsidies are critical for Alaska’s economic development, and its government’s capacity to provide basic services for its citizens. The logic of these arguments is that Americans – placed in the position of judging the merit of a series of federal programs cold, and lacking the actual justification for the program – would join him in cutting a huge swath through the federal budget.
Reasonable people might be forgiven for suspecting a more complex relationship between taxation and economic performance. At the state level, every recent instance where governments have attempted to significantly reduce the size and scope of their state budgets has generated little-to-no economic stimulation, or produced economic declines. Furthermore, these attempted retrenchments have provoked fierce protests in protecting state services, illustrated by teacher walkouts in Oklahoma and elsewhere (e.g. Arizona, Colorado, and West Virginia).
Some Americans agree with GOP anti-tax activist and Americans for Tax Reform President Grover Norquist’s aspiration to reduce the size of the federal government that it could be “drowned in a bath tub.” Such anti-tax fervor is understandable. After all, who actually enjoys paying taxes! However, pursuing the kinds of comprehensive reductions of federal programs comes with serious consequences. As a recent column in Foreign Affairs by the Nobel Prize economist Joseph Stiglitz and two co-authors notes, it “takes money to build roads and ports, to provide education for the young and health care for the sick, to finance the basic research that is the wellspring of all progress, and to staff the bureaucracies that keep societies and economies in motion.”
Frequently, advocates’ justification dramatic tax cuts implicitly invoke a variant of the “difference principle,” a distributive principle arguing only those inequalities that benefit the least advantaged are justified. Fiscal conservatives contend that tax cuts can be counted on to unshackle entrepreneurship, amounting to a libertarian equivalent of the “rising tide lifts all boats” justification that John F. Kennedy invoked for massive infrastructure projects like the McClellan-Kerr waterway, which since its opening in the early 1970’s has supported billions in economic activity for Eastern Oklahoma. For freshwater economists, reducing taxes benefit the least advantaged in society by providing jobs, and for supply-side advocates like Arthur Laffer, state revenues lost through tax cuts are replaced by increased productivity.
The past forty years of the relationship between taxation and economic performance offer evidence for skepticism that taxes cuts act like “rocket fuel,” a phrase Kansas Governor Sam Brownback employed in announcing massive tax cuts in his state. To date, such cuts at the federal and state level simply do not reliably provide the kind of stimulus advocates predict. The difficulty with supply-side theory (or any theory, for that matter) is not that it’s “wrong,” per se, but the assumption that incentivizing profit- seeking is economically stimulating is conditional rather than invariant.
The beneficiaries of tax cuts, be they for corporations or the “captains of industry,” step up productivity only if they see a clear avenue for advancing their economic self-interest; otherwise, not. Self-interested, the wealthy will seek to shelter any windfalls from tax cuts rather than risk it on ventures they might reasonably calculate are unlikely to succeed.
Simply put, tax cuts are not a cure-all. The current economic environment, particularly in the aftermath of our current pandemic, will likely require prudent investments in strengthening the middle class, and rebuilding the pathways for low-income Americans into the middle class. Rebuilding America’s infrastructure, raising the minimum wage, lowering (but not eliminating) the costs of higher education, and dramatically improving the overall quality of public education are far more prudent ways of investing in the common good than continued tax cuts. With taxes, as with much in life, you get what you pay for.
Dr. Ken Hicks is professor of political science at Rogers State University. The opinions, beliefs, and viewpoints expressed in this column are those of the author, and do not necessarily reflect the official position of Rogers State University.