Monday, April 28, 2003

Taxes and Interest Rates-Josh wanted me to comment on his post on tax cuts and interest rates; here's my quick take before I have to head off to a 3:00 MBA committee meeting; more in the next 24 hours. The classic view of interest rates is that it is made up of a "real" interest rate plus expected inflation plus any risk premia. However, from the investor's vantage point, taxes need to be taken into account. For the moment, let's ignore risk premia and look at the T-bill market, where maturity risk is negligible.
After-tax return =[ (1+Real Rate) (1+Expected Inflation)-1] * (1-Tax Rate)
If you run a deficit, you are going to increase the real interest rate, for you'll need to raise interest rates in order to coax people who'd otherwise want to invest in stocks or private-sector debt into buying the Treasury bills and bonds needed to finance the debt. That will lower the total amount of money available for private investment, slowing economic growth; economists refer to that as the Crowding-Out Effect. However, people ignore the effect the tax rate will have on this equation. With lower tax rates, investment looks more attractive. Some of the money people received from the tax cut will be saved; in fact, many critics of tax cuts will point out that the Bush tax rebate of 2001 was saved rather than spent. Temporary tax cuts tend to have a higher percentage saved as opposed to the permanent (or at least until the next tax-happy majority) tax cut that is being proposed. Even so, a permanent tax cut will see a growth in the amount of investment due to people having extra take-home pay. In addition, the lower tax rates will make investments more profitable. Lower tax rates mean higher after-tax income; as people are making the save-versus-spend decision of "Goodies now versus More Goodies later," the tax cut will give them extra goodies in the future. That will also lead to more investment. If we assume that investment is a normal good compared with current spending, investment would go up due to more money being available at present via the income effect and go up more due to the substitution effect of higher after-tax returns. Thus, you could have seen interest rates go down in the 80s both from the Volker Fed clamping down on inflation and from the Reagan tax cuts reducing the tax rates and increasing the investment take-home-pay. The combination of lower taxes and lower inflation helped to counter the crowding-out effect. In the 90s, you had a continuation of a tight monetary supply and gridlock leading to budget surpluses. Even though we had higher taxes due to Bush 41 and Clinton (the tax cuts of the mid-late 90s only partly undid the raises), the lower real rates and continued low inflation offset the increase in taxes to create stable interest rates. Now, in the 00s, you have Dubya cutting taxes and running a deficit. The Greenspan Fed's keeping a lid on inflation, although a somewhat sluggish economy tends to make his job easier. Thus, a tax cut should counter the crowding out effect by producing more money to invest that will offset the money the government's needing to borrow. If the tax cut adds to net private sector investment, the tax cut will help the economy to grow.

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