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Income Tax Increases Will be a Drag on the Economy

Our budget deficit woes will end up making tax increases inevitable. We are far too deep in debt to grow our way out of the problem. In addition, our deficit has become too large for spending cuts alone to fix the problem. The day of reckoning is approaching faster than anyone had imagined before the financial crisis hit.

Simply put, higher income taxes are a drag on economic growth. They take money away from private investors and put it in the hands of government. We know from history that governments are poor allocators of capital. Government operates at a much lower level of productivity than the private sector.

Government expenditures, unlike private businesses, have a flat to negative multiplier effect on the economy. The historical data was outlined in This Time It’s Different by Reinhart and Rogoff. In comparison, the private sector generally has a positive multiplier effet on the economy. That is, each new dollar invested by businesses and investors will boost economic growth. Government expenditures, on the other hand, drain money out of the economy.

Tax increases often follow financial crises. This is because a financial crisis leads to bailouts of multiple companies, usually banks. Governments tend to borrow a big portion of this money, thus raising the budget deficit. In addition to bailouts, government expenditures also rise from economic stimulus programs. This is because a bad recession almost always follows a financial crisis. At the same time, tax revenues drop after a financial crisis because individuals and businesses are making less money; thus, having less taxable income. This is why banking and financial crises result in a downward spiral.

In the end, deficits have to be dealt with. Governments try to fix budget problems through inflation, reduced spending, and tax increases. Tax increases often fail because they lead to slower economic growth or could possibly trigger another recession. The result of the tax hike is even lower profits for businesses and less income for individuals. Therefore, the intended tax increases can generate less tax revenue for the government. In some situations, this only makes the problem worse.

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Filed under Economy, Taxes