How does government spending affect the economy?

Tax policy and the economy

In the economic discussion it has usually been assumed that the level of government expenditure is independent of the level of tax revenue, and the conclusion drawn from this is that an increase in tax rates and a resulting increase in the budget surplus is a restrictive policy. In a realistic view, it must be admitted that this independence does not always exist. Under the prevailing conditions in Germany, government spending could well fall if tax rates were reduced. This does not mean, however, that for every 1 billion reduction in tax revenue, public spending would also fall by 1 billion. If that were the case, there would hardly have been an opportunity to erect a July tower and to derive from this policy the economic policy advantages to be mentioned later. At best, government spending would fall by a fraction of the reduced revenue. On the other hand, one must assume that in the current boom the increase in private spending would not lag far behind the amount of the decrease in tax revenues. So we come to the conclusion that tax cuts tended to increase private sector spending more than reduce public spending. The overall effect would therefore be expansionary and not appropriate in a boom situation that requires restrictive measures. At the same time, of course, a reduction in government spending with constant tax rates (that means an increase in the July tower) remains desirable in terms of economic policy; however, this requires recognition of the economic function of surplus policy.

Tax cut and savings

It is further argued that a tax cut is desirable from an economic point of view if it helps to increase savings. This is the purpose, for example, of proposals aimed at equipping a general income tax reduction with special benefits for the formation of savings capital.

This argument would be acceptable if one could assume that a tax cut, which leads to additional savings in the same amount, does not result in greater investment expenditure, i.e. it does not have an expansive effect. Such a tax cut would be neither conducive to nor detrimental to the objective of total spending restraint and would therefore be more beneficial than a tax cut resulting in greater consumption expenditure. But this assumption is hardly accurate under the present circumstances. Increased saving would undoubtedly have an increase in investment and an increase in capital expenditure would lead to the same expansionary effect on total demand as an increase in consumption expenditure. At best, one might conclude that a tax cut aimed at consumption increases aggregate demand somewhat more than a cut aimed at saving; but one must not fail to recognize that the latter measure (apart from the already mentioned possibility of reducing government expenditure) has an expansionary effect on balance.

But this is not important here because the current discussion is taking a completely different path. On the one hand, it is asserted that the additional savings do not lead to additional investments at all, but only replace the bank loans previously used to finance the investments. On the other hand, however, it is also emphasized that additional investment expenditures are necessary to rationalize the economy and thereby to provide an increased supply of goods.

As regards the first variant, the argument is based on the premise that the volume of investment is a given quantity that would not be affected by the tax cut. But this is no more the case than it can be assumed that the level of investment expenditure is independent of monetary policy. Tax cuts without compensatory restrictions in monetary policy lead to an expansion of investment. Should it appear desirable - albeit more for structural than for cyclical reasons - to finance a larger part of the investment from savings and a smaller part from money creation, this goal can be achieved through a combination of measures, i. H. Tax cuts (especially in favor of saving) on ​​the one hand and greater restrictions on the possibility of borrowing on the other. A tax cut without further credit restrictions would have a structural effect in the same direction, but only in connection with an increase in capital expenditure and therefore a larger rise in prices.

As far as the second variant is concerned, it is probably correct that an increase in real business investment (insofar as this is at all possible with full employment) leads to greater production capacity and a faster increase in national income. This then makes it possible to meet larger wage demands without the risk of inflation. In principle this is correct, but it must be noted that this is a very slow development and also that the role of investment in the rebuilt economy is different from that in the first post-war years. The enormously high average growth rate of the German national income during the last few years cannot of course be sustained in the long term; it was largely the result of the rebuilding of the ruined economy, a process that has now largely come to an end. As in other countries, further growth in national income will depend on normal factors, in particular on population growth and increasing productivity. In this situation it can no longer be expected that an increase in capital expenditure will have a deflationary influence on the price level. For example, if capital expenditures are increased by 1 billion, demand first increases by 1 billion; With full employment of the production factors, however, this increase in demand will only be compensated to a small extent by an increase in total production, so that overall demand is also expansive and inflationary, but not deflatory, as is often claimed.

It can of course be argued that this expansion of aggregate demand can be avoided by contrasting the larger investment with lower consumption. However, this means lower taxation on saving and higher taxation on consumption and not, as the debate suggests, a general tax cut. Assuming that such a change would also be possible in principle, it remains questionable whether it would be desirable at all to increase capital formation in the current situation. The share of capital formation in national income is extraordinarily high in Germany; this is evident both from a comparison with previous years and from a comparison with other countries, and it is not at all obvious that this development should be strengthened in the longer term. It should also be noted that rationalization does not necessarily mean an increase in net investment, because improvements in the production apparatus can largely be financed by reinvesting the depreciation amounts.

If all these considerations are made, one can hardly avoid the conclusion, which is also expressed in the last monthly report of the BdL, that a restriction of both investment and consumption expenditure is necessary for economic policy reasons. The same is, of course, true of public spending, although it cannot simply be assumed that public spending (i.e., in practical terms mostly "social spending") must always be the first to be reduced.

Tax as an incentive to invest

Now it is not only argued that a tax reduction is necessary because one needs more investment or more self-financing of the investment, but it is also argued - and sometimes in the same breath - that one should lower the high taxes, since taxation encourage excessive and inefficient investment and spending. This thesis, according to which a tax cut leads to a reduction in expenditure, includes two arguments: the first relates to the effects of the accelerated depreciation option introduced in 1953, and is largely correct; the second relates to the general impact of high tax rates, and in my view is largely wrong.

Accelerated depreciation is a taxpayer benefit that has a positive impact on investing for a number of reasons. By faster, i. H. increased depreciation, the tax burden is delayed, so that more equity is initially available for investments. Since this type of financing is often preferred to borrowing or issuing securities, accelerated depreciation initially leads to greater investment activity, and the deferral of the tax liability until a later point in time, which is brought about by shortening the depreciation period, represents a reduction in the current value of the tax liability and thus equates to a certain reduction in the tax rate for a given depreciation period. Finally, the investment incentive of accelerated depreciation is particularly significant when the taxpayer expects the tax rate to be lowered in the future. The costs of the "new" investments are then offset against the profits of "old" investments that are still subject to the high tax rates, while the profits of the "new" investments are only subject to the later and lower tax rates. So it would be worth investing that are planned for the future to be brought forward to the present, and current levels of investment are increasing.These forces have undoubtedly been at work in recent years, although the extent to which they are blamed for the high level of investment is arguably greatly overestimated Anyway, it is certainly true that lengthening the depreciation period (or decreasing the depreciation rate within a given period of time) would be restrictive if tax rates remained the same, but such a measure would in essence be more like a tax increase.

Apart from the question of the depreciation period, it is argued that higher tax rates generally lead to greater investments or other business expenses. This argument goes roughly as follows: The acquisition of certain business assets costs 100,000 DM gross. These additional costs can be written off against profits of 100,000 DM (depending on the nature of the additional expenses, the amortization is the same or later), and this results in a tax rate from, say, 60% to a reduction of the immediate tax liability by 60,000 DM. The net costs of the plant have thus been reduced to 40,000 DM through the existence of the tax. This example shows that the incentive to make such expenses has increased. In short, the higher the tax rate, the lower the effective cost and the greater the incentive for additional spending. This result somehow contradicts common sense, because it would only be necessary to impose high profit taxes in order to overcome a depression.

The missing link in the argument is the fact that the tax not only stimulates tax savings through additional expenditure, but that future income from this additional expenditure will also be subject to the tax again and will therefore be less attractive. When this is taken into account, our arithmetic example looks like this: Assume that the gross return is 10% and compare the net return with and without tax. The entrepreneur has a gross profit from previous investments of 100,000 DM. As long as there is no tax, he can reinvest this profit, can earn 10,000 DM and then later has 110,000 DM at his disposal. Or he can already take out 100,000 DM for consumption. The reward for the investment is 10% of the amount that could be withdrawn right now. Now we assume that a tax of 60% is imposed, and we start again with the assumption that the entrepreneur has a gross income of 100,000 DM from previous investments. He now has the option of paying a tax of DM 60,000 from this gross profit of DM 100,000 and then taking a net profit of DM 40,000; or he can do without this 40,000 DM and make an additional investment of 100,000 DM. Also, to simplify the argument, let us assume that these additional expenses are of such a nature that they can be written off immediately. In this case, the tax liability is postponed and the entire gross profit from the past investment is available for new investment. The gross income from this new investment is 10,000 DM, so that he will later have a gross amount of 110,000 DM available for withdrawal. After deducting the tax of 66,000 DM, 44,000 DM remains as net income. So there is a choice between an immediate net income of 40,000 DM and a later net income of 44,000 DM. As you can see, the reward for the investments is again 10% (or 4,000 DM out of 40,000 DM), just like it is before the tax was imposed. The profitability and thus the incentive to invest has remained unchanged.

Contrary to a widespread view of practitioners, it is incorrect to say that high tax rates increase the return on investment and thus give rise to additional expenses in the event of economic behavior. Where it is an investment from existing capital and not a reinvestment of income subject to taxation, it can also be shown that the tax reduces the profitability of the investment and thus gives rise to investment restrictions.

However, certain exceptions to these conclusions should be noted. One is the possibility, already mentioned, that a reduction in future tax rates is expected, especially if this is combined with a short depreciation period. This can be remedied by extending the depreciation period and not by announcing a tax reduction. Another possibility, though improbable, is that the entrepreneur has absolutely no intention of ever extracting the amount invested, so that constant reinvestment of profits amounts to constant running away from taxes. Finally, it must be noted that taxes can encourage larger expenses and other expenses that are actually more consumed by business people than actual business expenses. Here it is of course quite correct that a high income tax rate makes it advantageous not to pay out wage subsidies or gratuities in cash because they would be subject to income tax, but in the form of remuneration in kind (e.g. company cars that can also be used for private purposes ) that escape income taxation. However, this belongs to the special problem of determining the concept of income, the difficulty of which increases with the level of the tax rate.


The above considerations indicate that a tax cut would be inappropriate in the current economic situation. The resulting increase in private spending would likely outweigh the actual decrease in public spending. Tax cuts, which lead to increased savings, would largely result in increased investment demand, and under the circumstances this would have little less, and perhaps even greater, inflationary effects than an expansion in consumption demand. It seems generally incorrect to say that a tax cut would reduce investment and business spending. Extending the depreciation period would restrict the investment and is desirable, but it implies a tax increase rather than a tax decrease. Finally, the question must be raised as to whether it is desirable to lower taxes at a time when it is necessary to prepare for greater defense spending. The reference that the funds pent up in the "Juliusturm" could be used for this purpose is incorrect from an economic point of view.The construction of the tower has had a useful deflationary influence over the past few years, and thus largely facilitated the central bank's task of keeping net money creation within reasonable limits. The lack of recognition of this fact in the current discussion, and the almost unanimous criticism in the business press that the construction of the Juliusturm was a mistake, can only be explained by the fact that its architects themselves less the economic policy value of the withdrawal of money than hardly convincing accounting Arguments in the field.