Taxes and Economic Incentives, Essay Example

Taxes and economic incentives have long been presumed to considerably influence both business location and personal mobility. While the general perception has been that lower taxes would generally lead to an influx in population growth and migration, personal mobility is not considerably affected by taxes but the quality of living (Tannenwald, Shure and Johnson). While taxes may reduce the amount of disposable income to individuals, when directed to proper public investment and spending, it would considerably improve the living standards of individuals within the economy.

Public Investment and Government Spending

Government can increase productivity within the economy through increasing public investment. Investment is an important function and factor of production, growth and development. In order for government to realize tangible economic growth and development, it has to foster public investment without the risk of creating deficits (Zidar). Tax cuts and economic incentives usually lead to the re-directing of the government’s cash flows. This reduces the amount of revenue realized by government and as such the disposable revenue set aside for savings and investments.

The reduction in public investments has considerable negative effects on the economy. The most significant effect would be the reduction in productivity within the economy. Public investments help the economy generate more income and output.

Taking the example above, Government spending has a similar effect on the equilibrium output that investments have. This is because when government expenditure increases, the amount of capital available for investment by businesses within the economy also increases by a similar amount. This means that aggregate expenditure is increases with government expenditure. This is known as the government spending multiplier effect.

On the other hand, an increase in taxes has a much smaller effect on equilibrium output as compared to government spending. The tax multiplier is much smaller than the government spending multiplier for one main reason, the actual amount of money invested into the economy. When government chooses to reduce taxes, it chooses to not make money through the economy (Lynch). This reduces the amount of money that individuals have to pay to government in the form of taxes. However, this new available income will not be completely invested in economic activity. However, some of this money would be directed into household expenditure. When government increases expenditure, all of the money is directed to investment. For this reason, the effect of the government spending multiplier on equilibrium output is much larger than the tax multiplier.

Physical Capital

Physical capital, by definition, is the tangible assets that an economy or business entity has access to. Physical capital can however be made available through the introduction of foreign currency into the economy. This is mainly achieved through attracting foreign investors into an economy. This is essential in providing the much needed finances to acquire the physical resources.

In order for government to ensure continual flow of foreign currency through foreign investment, government may opt to introduce a subsidy to physical capital, such as machinery and equipment, through a tax subsidy (Lynch). The subsidy is meant to affect the amount of physical capital available within the economy. This is turn directly affects the amount of physical resources businesses have access to, in-turn influencing the amount of output that the economy realizes.

While a subsidy may affect the rate at which growth is realised, the effect is minimized to level effects if there are insufficiencies and/or redundancies within the production processes employed within the economy. When production processes are not optimized to realize maximum utility, then the growth rate cannot be affected by tax incentives or subsidies.

Government Deficits

Tax cuts and government subsidies are known to reduce revenue realized by organs of the government. This is because these tax cuts and subsidies directly affect the government’s cash flows, by either directing these cash flows to the intended sector, or avoiding these cash flows all together. A reduction in government revenue leads to an increase in budgetary deficits as there is little financial resources available to finance government activity.

The most recent and salient example of this concept is evident in the rejection of President Barrack Obama’s application to have the period of the Bush Tax-cuts extended. The temporary reduction in payroll taxes from 6.2% to 4.2% for 2011 and 2012 were meant to alleviate the burden and strain of taxes on citizens owing to the previous recession that the economy had experienced (Zidar). President Obama’s bid to extend the period of the Tax-cut was declined. The Budget Enforcement Act of 1990 would have hurt his chances of renewing the payroll tax cut.

This is because, the Budget Enforcement Act of 1990 moved from fixed-deficit reduction targets by limiting deliberate actions by the congress that may in one way or another increase the deficit. This act implemented the “pay-as-you-go” system. This system requires that any changes in taxes be deficit-reducing or deficit-neutral. This meant that tax cuts would have to be counterbalanced by a corresponding decrease in spending or an increase in revenue.

Towards the end of 2012, the Fiscal Cliff was projected to be able to increase revenue by 19.63% and reduce government spending by 0.25%. This would eventually lead to a reduction in deficit position of the government (Zidar). This would have also led to a minor recession which would have been characterized by a slight increase in unemployment. However, the labor market would strengthen and economic growth would be boosted.

The proposal by President Obama would have only led to an increase in the deficit position of the government, against the requirements of the Budget Enforcement Act of 1990. By extending the tax-cut, government would have experienced a reduction in revenue and an increase in expenditure. This would have further increased the government’s budgetary deficit. The Budget Enforcement Act of 1990 mandates that any changes to be made to the budget and taxation policies would have to be deficit-reducing or deficit-neutral. The president’s proposal to extend the tax cut would have been deficit-increasing on the contrary.

Effectiveness of State Economic Incentives

State economic incentives are generally expected to spur growth and development within the economy by increasing the amount of disposable capital and income to businesses and individuals. However, these disposable income is not fully utilized as accounted. Since this disposable cash flows are directed to businesses and individuals, they will not all be directed to the intended purpose accounted for. Most companies would either declare dividends, while individuals may spend the money on anything other than investment. This necessitates the use and application of government spending as a more effective multiplier that a reduction in tax, embodied in the much weaker tax multiplier.

In conclusion, tax and economic incentives considerably increase the amount of disposable income to businesses and individuals within the economy. However, they do not significantly affect business location and personal mobility. Business location is affected by other factors such as the availability of support services, affected by government spending. Personal mobility is also affected by the availability of economic resources and social amenities, affected by public expenditure and investment. As such, tax and economic incentives are neither effective nor valid, unless in tightly controlled environments.

Works Cited

Lynch, Robert G. Rethinking Growth Strategies. Washington: Economic Policy Institue, 2004. Print.

O’Brien, Michael. “House votes to extend current tax rates after shooting down Obama plan.” NBC News 2 August 2012. Electronic Source. 15 April 2015. <http://www.nbcnews.com/id/48459406/ns/politics-white_house/t/house-votes-extend-current-tax-rates-after-shooting-down-obama-plan/>.

Tannenwald, Robert, Jon Shure and Nicholas Johnson. Tax Flight is a Myth: Higher State Taxes Bring More Revenue, Not More Migration. Washington: Center on Budget and Policy Priorities, 2011. Print.

Zidar, Owen M. Tax cuts for whom? : Heterogeneous effects of income tax changes on growth and employment. Cambridge: National Bureau of Economic Research, 2015. Print.