Relationship between budget deficits and tax cutting

Introduction

A budget deficit comes about when the government’s spending exceeds government revenue. That is, income from taxes and other sources are not adequate to meet the expenditure. In most cases, budget deficit calls for either external or internal borrowing or increase of taxes. On the other hand, tax cuts refer to reduction in the rate of taxes. Tax cuts impact the economy by reducing the real income of the government while increasing the real income of the taxpayers.

Current situation on budget deficits

In the United States, the famous Bush Tax Cuts were introduced in 2001 and 2003. These cuts were supposed to expire in 2010 but President Obama agreed to extend them to the next two years up to 2012. His reasons behind tax cutting were to encourage investors and enhance creation of employment.

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Within the first four years of the tax cut, revenues had gone down by around $474 billion with the overall decrease being $2.4 trillion to date (CBO 18). President Obama has also assented tax-cutting laws, including the American Recovery and Reinvestment Act (AARA) and the Recovery Act, which is worth $243 billion by the year 2012. These are meant to benefit each American household and reduce family’s income tax payments by $800.

The December 2010 taxes deal “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, is said to cost $400 billion” (CBO 20). All these cuts put together, are going to amount to $654 billion in 2011 and 2012. The difference between Obama’s tax cuts and Bush’s is that, Obama mostly targeted the middle class and even distribution of wealth, while bush was skewed to the few rich. Secondly, Obama’s tax cuts are temporary and most likely to expire next year.

The problem

In august 2011, the monthly deficit was $44 higher than the amount recorded last year the same time. In total, the government spent $303 billion and gathered $169 billion.

The deficit skyrocketed to $1.41 trillion in the 2009 financial year. According to the 2012 budget of the United States federal government issued on February 14, 2011, by President Obama, the total expenditure is going to be $2.627 while the total revenue collected will amount to an estimated $3.729 trillion. This implies that there is an estimated $1.101 trillion budget deficit in 2012 (CBO 115).

As indicated by statistics in the current situation, tax cuts have led to a reduction in government revenue, whether permanent or temporary. Some economists argue that the tax cuts initiated by Bush were meant to benefit the high-income households by far. He allegedly gave tax cuts to the rich along with tax breaks, although others claim that the benefits extended to both the middle and lower income earners.

The10 year’s tax cut decreased the revenues because they led to the rich paying fewer taxes, yet they should make the biggest contributions to government revenue. The tax cuts did not benefit middle and low class, and thus provision for services called for greater spending.

Bush did not look at the long-term effects of the tax cut. Some look at it as a case where the tax cuts could not “pay for themselves.” Although, the policy could have worked in the first quarters, in the overall, it left the economy with 9.1% unemployment and fall in revenues.

Economic explanation of the problem and reasons

When Bush came up with the tax cuts in 2001 and 2003, perhaps he was being influenced by supply-side economics. According to supply-side economics, tax reductions can be used to stimulate investments and create employment. However, this effect cannot be achieved without balancing the decrease in revenue and reduction in government spending.

This is because a tax cut leads to a fall in real income for the government, but a rise in real income to those whose tax has been cut. When investors experience increased real incomes, they lead to increase in investments, and thus creating more jobs. If the real income of consumers increase, they are more likely to spend and thus stimulate small and medium enterprises and the economy in general. However, this economic phenomenon is determined by behavior of taxpayers (business or consumers) (CBO 35).

If this concept does not work, then investments and growth expected will not materialize. If the government accommodates tax cuts, it must initiate measures to reduce government services and spending in general and enhance its capacity to redistribute wealth to avoid income inequalities. Tax cuts cause budget deficit when governments spending does not reduce to compensate the effect of lost revenue.

They also cause deficit if the tax cut benefits the upper class wealth owners and thus real incomes of consumers do not increase to stimulate investments leading to employment and growth of output. This leads to increased spending on unemployment benefits, heath care, and Medicaid, therefore leading to deficits. Additionally, implementation of tax cut should be as progressive as possible to ensure that tax savings do not go to rich investors or executives who might not use it to create employment.

Economic explanation of the solution

To address budget deficit, various fiscal methods can be adopted. First, the government can raise taxes to increase their revenues to match their expenditure. Secondly, the government can reduce its public spending especially on capital projects that do not have short-term effect on economic growth.

The government can as well reduce expenditure on services like freezing non-defense optional spending, capping subsidies for instance in some sectors like farming, reducing Medicaid rate by around 5%, substituting Medicare drug benefit with drug card, and sinking entitlement on spending by 2 or 3 percent through target of fraud, waste, and exploitation(CBO 135).

The worst available option is to borrow, because the interest rates get sour in deficits. In addition, this further accumulates public debt hence possibility of the economy falling.

Increasing taxes is the most appropriate way to curb budget deficit due to its ability to increase government’s income and at the same time reduce income inequalities. Income inequalities hinder many economic tools that are used to run the economy, both fiscal and monetary.

When an equitable tax system is used, it achieves both the objectives of increasing investments, employment, and output. The raise in taxes should be realistic to avoid scaring off investors or disadvantaging a section of the society especially low-income earners who influence government spending. The best solution is to have a mixture of both increase in taxes and reduced government expenditure.

Conclusion

Tax cuts undoubtedly affect budget deficit in a big way especially due to revenue. If tax cuts are meant to stimulate growth, the government should majorly focus on the behavior of the taxpayer and economic climate like inflation, otherwise it could lead to large deficits.

The government should target a certain group of the public that is more likely to compensate revenue lost in form of taxes. It is also important to avoid or carefully examine long-term effects of tax cuts. To get a solution to budget deficits, it is important to instill a mix of reducing government expenditure and equitable rise in taxes.

Works cited

Congress of the United States: Congressional Budget Office (CBO). Reducing the deficit: spending and revenue options. 2011- September 30, 2011.
< http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10 ReducingTheDeficit.pdf>

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