The Prime Minister recently announced that next year’s Budget will feature tax cuts for all, but particularly for the middle class. He described the proposed cuts as “historic”, though it is not clear what he meant exactly. On another occasion, he mentioned a tax cut of €600 for the middle class, tax cuts for lower-income people (presumably not to the same extent), but also spoke of businesses enjoying adjustments to the tax rates that they pay.

I can understand that the Premier might not want to disclose exactly what is being proposed at this stage.  But, in other countries, an independent entity   ̶   the equivalent of our Malta Fiscal Advisory Council   ̶   would already have been requested to provide estimates of the impact of such tax cuts, whether on individuals, businesses or the Government’s fiscal balance, not to mention on economic growth and other parameters such as labour costs and inflation. 

Economists like me would be interested in learning how the tax cuts would affect household and government behaviour, in order to assess whether they might increase national saving and capital formation or not. That’s important, because extra savings can bolster future productivity and living standards by bumping up the supply of capital used by business to purchase plant and equipment.  So, will they do so?  Theory might tell you one thing, but experience might show a different story.

Research

These issues have been well-researched in other countries over the years. For example, Alan Auerbach of the National Bureau of Economic Research in the USA has specifically examined whether tax cuts spur economic growth and what impact they have on savings. Auerbach focused on the net national saving rate   ̶   the share of net output that is consumed by neither government nor households   ̶   as a prospective measure of the rate of capital accumulation.

He used a dynamic model that takes account of any feedback on the economy in the way of extra economic growth, and thus additional government revenues, stimulated by a cut in marginal tax rates. His simulations suggested that tax cuts may indeed increase saving in the short run   ̶    but depending crucially on assumptions. Also, they are likely to increase economic output in the short run, because of their auxiliary beneficial effects on labour supply.  Lower tax rates encourage individuals to work more while those with higher incomes are able to save more. The dynamic feedback effects are considerable: they compensate for as much as 10 to 40 percent of the revenue losses indicated by static calculations of the impact of tax cuts.

But the benefits are not large enough to offset the negative impact of tax cuts on national saving. In the longer run, saving and output are likely to fall once the revenue losses generated by the tax cuts are confronted through necessary policy changes. Those could include tax hikes or spending cuts to reduce fiscal deficits. Only if the revenue losses are entirely offset by reductions in government spending can the long-run drag on the economy be avoided, Auerbach finds.

Economic growth?

Politicians often promise that tax cuts will lead to higher productivity, higher economic growth, and even pay for themselves through a boost to long-term incomes. These promises may curry favour with the electorate which tends to prefer promises of tax cuts. But do tax cuts really increase economic growth?

There are two impacts of lower taxes: (1) increasing demand in the short term, and (2) the effect on supply and productivity in the long-term.

Lower income tax rates increase the spending power of consumers and can increase aggregate demand, leading to higher economic growth (and possibly inflation). On the supply side, income tax cuts may also increase incentives to work – leading to higher productivity. However, the effect of tax cuts depends on how the tax cut is financed, the state of the economy and whether low tax rates actually increase productivity and the willingness to work.

What are the potential effects?

The effects of reducing income tax rates can be in three areas:  

Increased spending: Workers will see an increase in their discretionary income. With lower income tax rates, they would keep more of their gross income, so effectively they have more money to spend.

Higher economic growth: With lower tax rates, we could expect to see a rise in consumer spending because workers are better off.  Because consumers spending is a component of aggregate demand (roughly 60%), then a rise in consumer spending should cause a rise in AD, leading to higher economic growth.

Government borrowing: Tax cuts will, ceteris paribus, lead to lower tax revenue and this is likely to cause higher borrowing. Though some economists believe income tax cuts can increase productivity, which offset this fall in revenue. The effect of tax cuts depends on whether the economy is operating below or above full capacity.

Will a cut in tax really increase aggregate demand? Firstly, it depends on how the tax cut is financed. 

Tax cuts financed by spending cuts. Suppose the government offered €14 million of income tax cuts, but at the same time cut €14 million from its expenditure. In this case, we will not see an increase in AD because some people are better off from the tax cut, but others will cut their spending due to lower receipts from government. There is no overall increase in injections into the circular flow of income.

Government borrowing. Alternatively, the government could finance the tax cut by increasing government borrowing. Would this increase AD?  In a recession, we probably would see higher AD. This is because the government borrowing will be financed by people wanting to save anyway. In this case, the government is injecting unused resources into the circular flow. In a recession, the tax cut makes a big difference to people’s spending power.  In a full-employment economy, things will be more complicated.  People may not want to save more and would therefore seek to increase their spending.  But if the economy is already operating at full capacity, the likelihood is that the increased AD will lead to inflation.

If the government increases borrowing in a boom to finance a tax cut, we are more likely to get crowding out. This essentially means the government borrows more by selling bonds to the private sector. If the private sector buys government bonds, they have less money to invest elsewhere. Also, during high growth, higher borrowing may lead to higher bond yields, and these higher interest rates cause financial crowding out. The tax cuts could also cause a rise in import spending and an increase in the current account deficit

Tax cuts financed by improved productivity. If the economy is experiencing rising productivity), which is not the case in Malta), then this can finance tax cuts. For example, if an economy saw productivity growth of 4% a year (e.g. due to new technology) then this high rate of economic growth would automatically lead to higher tax revenues (higher VAT, corporation tax). With this kind of economic growth, it may be possible to cut tax rates – but maintain tax revenue.

If we take a cut in income tax, it could also affect the supply side of the economy. For example, lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. Lower income tax rates may encourage people to move to that particular country. This is the so-called substitution effect – work is more attractive with lower tax rates.

However, there is also the so-called income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours. Therefore, tax cuts may not increase labour supply because people don’t need to work more if work is more highly paid.

A controversial economic argument is the so-called “Laffer Curve“. This argues that if you cut income tax rates, then the tax cut increases the incentive to work so much, that the government can actually gain more tax revenue. It seems to offer the best of both worlds – lower tax rates and higher tax revenues.

There is a debate about the extent to which tax cuts increase productivity and economic growth. If marginal income tax rates are high, then cutting tax rates is likely to increase labour supply and productivity. But, with tax rates of 20 or 30% (Malta’s is 35%), cutting income tax rates is no guarantee of increasing productivity and growth.

Another issue is the idea that consumers may respond to tax cuts by deciding to save more. The reason is that rational consumers may see a tax cut financed by borrowing will lead to future tax rises. Therefore, consumers don’t spend the tax cut but save it for future tax rises.

Studies on the effect of tax cuts generally show that economic performance, as measured by real GDP per capita and the unemployment rate, is not significantly affected by major tax cuts for the rich. The estimated effects for these variables are statistically indistinguishable from zero.  On the other hand, other studies show that cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of GDP by 0.3 percentage points per year.

Will the announced tax cuts in Malta also extend to the rich?  I certainly hope not.  They are the ones who, since Covid, have continued to increase their income and wealth, as is amply clear from various Central Bank of Malta studies.  They do not need, nor do they deserve, another bonus.  I believe it would be most un-Labour to increase inequality even further.

In 2018 Karel Mertens and José Luis Montiel Oleaanalysed time series data from 1946 to 2012 and found that marginal rate cuts led to both increases in real GDP and declines in unemployment. A 1 percentage-point decrease in the tax rate increases real GDP by 0.78 percent by the third year after the tax change. However, tax cuts for the top 1 percent do increase inequality.

In 2019, Owen Zidar examined the impact of US federal tax burdens on economic growth and labour supply across different income groups and states from 1950-2011. He found that a 1 percent of state GDP tax decrease for the bottom 90 percent of earners increases state GDP by 6.6 percent, increases labour force participation for the bottom 90 percent of earners by 3.5 percentage points and hours worked by 2 percent. He does not find any significant impact on labour force participation rates, hours worked, or GDP growth for the top 10 percent of earners.

In Malta

So, turning back to the proposed tax cuts in Malta, I could only do some back-of-the-envelope calculations since I have no idea whether the tax cut will be achieved by a reduction in the rate, a recalibration of the tax bands, an increase in deductions, or a combination of all three.  Assuming that the tax cuts would apply, say, to 88,220 households   ̶   the lower middle class through to the upper middle class   ̶    but exclude the working class (who do not pay or hardly pay taxes) and the wealthy class, an average €600 cut in taxes would set the government back by around €52.9m.  Assuming government revenue unchanged from 2023, the tax cuts would be around 0.82% of government revenue.  Again, assuming no other changes, they would increase the deficit by 0.27% and the public debt by 0.3% initially.

My very approximate calculations show that the proposed tax cut would be equivalent to around 1.76% across total households. So, assuming that the saved taxes are all spent and a 1% tax cut would boost GDP by 0.78%, AD might increase by 1.37% by the third year.  This leads me to conclude that the tax cuts would pay for themselves in some 18-24 months’ time and the hit on the deficit and public debt would therefore be short-term.    

Given the plight of the middle classes (see my previous opinions “That elusive Middle Class” and “Social classes blues”), I think this is a step in the right direction.  It is likely that most of the additional income available to households will be spent, not saved.  Though the increases in the deficit and debt are marginal, I believe that the Government should try to recover at least some of the revenue lost from the tax cuts through a higher tax rate on higher-income households and/or cutting down on unnecessary expenditure.

There might be some positive effect on the labour force participation rate, mainly by incentivising women to enter the labour market or to move from part-time to full-time work.  This would help attenuate the negative effects of the tax cuts.  As to the impact on inflation, one would tend to see some adverse effect given that we already have a full-employment economy but the actual effect will depend on a whole host of factors, not least whether the increased spending will be on local versus imported goods.  There might be some negative effect on the current account.  

Main photo: Adobe Stock