opinion

Kevin McGee: Why don't tax cuts work?

The December quarterly jobs report once again put Wisconsin in the bottom third of the country in job growth. Clearly, the governor's program of tax cuts is not working. It is not stimulating the state's economy. But how can that be? Isn't it common sense that lower taxes should increase economic growth?

To understand why that common sense is wrong, you need to know two things. First, taxes affect us because they change prices. And second, we respond to those price changes in not one way, but two. We respond because of the "income effect", and because of the "substitution effect."

Suppose this last Christmas you were thinking of buying a curved screen TV, until you saw they were selling for $1,800 and up. Who has $1,800 to spend on a TV? That's the income effect – prices affect what's affordable. The substitution effect has to do with the alternative uses of your money: you could buy four laptop computers for that same $1,800. Both effects make you less likely to buy high priced TVs.

So what does that have to do with taxes? Suppose you're working 36 hours a week, earning $16 an hour after taxes. That gives you an annual after tax income of about $30,000.

Now suppose your tax rate is cut, and that tax cut raises a price – your after tax pay – to $18 an hour. You have an incentive to work more hours per week, right? That's the substitution effect. You now get $18 for every hour you work, rather than just $16, so it's worth it to spend more time working, rather than doing other things. When people talk about taxes affecting incentives, they're talking about the substitution effect.

The problem is, that's only half the story. Because if you're now clearing $18 per hour, you can bring home that same $30,000 by working just 32 hours a week. Since you're making more per hour, you can afford to work less – the income effect.

When we look at people's actual behavior, we see both effects at work. Given a tax cut or a wage boost, some people respond by working more, and some respond by working less. Mostly though, most of us hardly respond at all, working pretty much the same amount. That suggests that for most of us, the two effects pretty much cancel out. And that says the predictions that look only at the incentive effects of a tax cut – the substitution effects – are generally going to be totally wrong.

Interestingly, there is one group in the population that consistently shows a strong substitution response to tax cuts – mothers of young children. For most of us, staying at home and not earning a paycheck is a lousy substitute for having a healthy bank account. But for moms, staying at home is a very good substitute for a job. After all, if they took that 36 hour a week job netting them $16 an hour after taxes, they'll have to spend a major portion of those earnings paying someone else to take care of the kids. Netting $18 rather than $16 an hour might be just enough to make taking the job worthwhile.

That's why childcare tax credits or deductions are good tax policy – they greatly improve the work incentive for moms. But for the rest of us, tax cuts have virtually no impact on our work behavior whatsoever.

But what about tax cuts on saving and investing? Tax cuts don't work on them either. But that'll have to be another column.

Community Columnist Kevin McGee is an economics professor at the University of Wisconsin-Oshkosh and a former member of the Oshkosh Common Council.