Tuesday, February 17, 2009

Why Individual Income Tax Cuts Won't Boost The Malaysian Economy

Now that the mini-budget has a date (March 10), speculation is increasing regarding what's going to be part of the stimulus plan. One idea that continues to be popular is the personal income tax cut - but as this article argues, the effect might be very small relative to the revenue loss to the government. In other words, there are better uses of the money that might have a greater impact on the economy. I find the line of argument a little confusing though - what the heck does "taxpayers’ role is a small proportion of the total labour force" mean?

Leaving aside the Laffer curve controversy (see:Reagonomics or Bushinomics), there's a very strong argument against using tax cuts to support economic growth. If, as the case should be here, the tax cuts (or rebates as the case may be) are expected to be temporary and will be lifted after the crisis, then rational economic agents would treat any such income as a windfall and save it rather than spend it. This means there would not be any boost in aggregate demand.

In real life, people aren't always fully "rational" in the economic sense - some of it will be spent, even if such spending is not logical and does not maximise utility. This was clear from the first Bush fiscal initiative just after the onset of the crisis, where there was a mini-boost to the economy in mid-2008. Nevertheless the boost was very short-lived, indicating possibly weak multiplier effects and reflecting the fact that the stimulus didn't resolve the underlying structural problems in the financial system.

Another issue with tax cuts is that it will only affect those who actually pay taxes. While I don't have the figures with me, my personal tax experience suggests that the lower-income group will receive little if any benefit from a cut in marginal rates. Unfortunately, this would be the group that would be most effected by the slowdown in growth, and need the most help. I'm thinking this effect is what the article meant by "narrow role of the taxpayer".

More to the point, a 1%-2% cut in personal income taxes won't actually release much money into the economy - at least relative to the stimulus required. Individual income tax only amounted to around RM12 billion in 2007, and under RM16 billion in 2008 for the first three quarters (much less than half of the take from companies). A 2% cut might put in RM1 billion into the economy, most of which would likely be saved. Remember that a cut in the rate effects mainly the top marginal rate, not the tax brackets necessarily. I'm doubtful whether a change in the tax brackets themselves might be effective either.

I'm more of the view that fiscal expenditure would probably be more effective, but that's a post for another day.

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