Why Preventing Budget Cuts Is Better Than Preserving Tax Breaks
By Chris Stiffler
As the state works hard to recover from the COVID-19 pandemic, it’s important we use the best economic strategies available to make sure our communities can come back strong. Unfortunately, much of the debate over how we do that has focused on trickle-down economics. If we make sure there’s plenty of money in the pockets of those with the most, we’ll all benefit down the line, or so advocates claim. In practice, however, it’s a different story.
We don’t have to look very far to see a perfect example of the failure of this philosophy. In 2019, after years of tax cuts designed to spur growth resulted in catastrophic budget cuts, Kansas was named the most-improved state for doing business by CNBC, their headline proclaiming: “Kansas economy rebounds from tax-cutting disaster.”
Other states aside, there’s plenty of evidence from right here in Colorado that shows designing tax policy to favor the rich isn’t the right move for policymakers who want the state to recover as quickly as possible. We can see the relative economic effects of keeping or ending preferential tax treatment for high-income business owners when we look at how people with different income levels spend their money.
Economists use the circular-flow-of-money model as a metaphor to describe how money is earned and spent. In a well-functioning economy, people earn an income through work and then spend it, which in turn becomes income for someone else who then goes out and spends it and so on. More money flowing means a stronger economy. In this way, one dollar spent can turn into multiple, which economists call a “spending multiplier.” A dollar saved doesn’t have the same consumption-boosting effect as the same dollar spent in a local restaurant. The biggest “injection” into the circular-flow model is government expenditures because they are, for the most part, buying salaries of moderate-income workers.
To see the net impact of a dollar paid in taxes by a high-income earner compared to a dollar of budget cuts, we need to explore what happens to a dollar held by an upper-income household and compare it to what happens if it’s paid in taxes.
Plenty of recent research demonstrates that the amount of a family’s income they spend, also known as their Marginal-Propensity to Consume (MPS), differs across incomes. Johnson, Parker, and Souleles (2006) find that the consumption response to the 2001 tax rebates were larger for households with low income.[1] Carroll et al. (2017) show that low-wealth households consume a higher portion of their income than upper-income households.[2] These differences in MPS are important in order to examine the impact of government fiscal policy, as suggested by Krueger (2012).[3] Fisher et al. (2019) show the rich spend a smaller share of their income than households in lower-income quintiles.[4]
Table 1 above shows middle-income households spend a bigger portion of their earnings in the local economy than high-income households. The average household spends 88 percent of their after-tax income in their local economy and 12 percent on life insurance, retirement, and savings. Meanwhile, a household making more than $200,000 only spends 55 percent of its after-tax income on expenditures like food, transportation, and entertainment. The reason for this difference is simple: someone making a low or moderate income is still paying the same price as a rich person on expenses like groceries and car repairs, so a larger share of their income goes towards those types of purchases, with less left over for them to save.
$1.00 in taxes paid by a household earning more than $200,000 a year reduces spending in the economy by $0.55 (the other $0.45 is either saved or used on life and disability insurance). When that $1.00 is re-injected in the form of the salary of a snowplow driver, teacher, or other public employee, the local economy gets $0.76 worth of spending.
How is that spending injection calculated? According to the State of Colorado Annual Compensation Report, 78.9 percent of a state employee’s compensation is base salary.[5] The remaining 21.1 percent goes to benefits (health and dental insurance) and retirement. Additionally, the state saves a bit, so we subtract an additional $0.03 to account for the state’s current general fund reserve. That leaves us with $0.76. This analysis suggests that re-injecting revenue from taxes on the wealthy into the economy as wages for public employees like teachers can increase aggregate consumption and boost economic growth. Conversely, it also suggests that preserving tax loopholes for the wealthy, and the corresponding budget cuts necessitated by that special tax treatment, is a net economic negative.
[1] Johnson, David, Jonathan Parker, and Nicholas Souleles. 2006. “Household Expenditure and the Income Tax Rebates of 2001.” American Economic Review 96(5): 1589–1610
[2] Carroll, Christoper, Jiri Slacalek, Kiichi Tokuoka, and Matthew N. White. 2017. “The Distribution of Wealth and the Marginal Propensity to Consume.” Quantitative Economics 8(3): 977–1020.
[3] Krueger, Alan B. 2012. “The Rise and Consequences of Inequality in the United States.” Council of Economic Advisers Address, January 12, 2012.
[4] Jonathan D. Fisher & David Johnson & Timothy Smeeding & Jeffrey P. Thompson, 2019. “Estimating the marginal propensity to consume using the distributions of income, consumption and wealth,” Working Papers 19-4, Federal Reserve Bank of Boston, revised 01 Feb 2019.
[5] Available at https://www.colorado.gov/pacific/sites/default/files/FY%202019-20%20Annual%20Compensation%20Report%20%26%20Director%27s%20Recommendation%20Letter.pdf
