While Democrats and Republicans rarely agree on anything, it’s no secret that tax policy and handling of economic issues are always a major point of contention. Historically, Democratic candidates have favored higher taxes, while Republican candidates typically favor lower taxes. Here’s why:
The rationale behind these taxation strategies is simple, but it isn’t always straightforward. In order to better understand where these policies and thought processes come from, you have to understand how most economists measure economic growth. They typically use Gross Domestic Product (GDP) as that measure. GDP is the value of all goods and services produced within a nation’s borders.
The GDP of the United States is made up primarily of 3 categories – Government spending, corporate spending/private investment, and consumer spending.
When GDP is positive, the economy is expanding. When GDP is negative, the economy is contracting. Every politician wants the economy to expand. Since they cannot control that through monetary policy – money printing and interest rate manipulation (only the Federal Reserve can do these things), their only option is to attempt to control it through fiscal policy (taxes and government spending).
This is what GDP looks like in our country today:
You may notice the total pie adds up to more than 100%. That’s because net exports, a smaller component of GDP, is a negative number and isn’t reflected.
But there is a problem with the relationship between GDP and tax rates that many lawmakers aren’t addressing. One strategy (lowering taxes) is meant to create growth by incentivizing private businesses to invest and spend money. The other strategy (raising taxes) is meant to create growth through government spending. Either strategy can work because both government spending and private investment DO affect GDP. The issue is that neither one fully addresses the elephant in the room – THE CONSUMER. The other issue is that the two strategies employed by politicians are mutually exclusive. You cannot typically raise taxes AND incentivize private sector investment. Likewise, you cannot lower taxes AND have more money for government to spend. Each philosophy targets the two smallest components of GDP – government spending and private investment. Why is that, and we hasn’t any political strategy focused on this?
Here’s one possible explanation – At various times in history, consumer spending has been a much smaller percentage of GDP…and government policies and political party platforms have not changed to address this issue.
Consumer spending made up only 58% of GDP in the mid-1960s. By the end of 2015, it was near 70%. As the U.S. has moved from a “production and manufacturing economy” to a “service economy,” the individual consumer has grown to account for a larger share of spending. The impact of changes in government spending or private investment on overall GDP is not as great as it once was because consumer spending is an even greater percentage of the total.
Throughout that time period, political parties have attempted to use the same traditional tactics that simply do not work in this new environment. Each can work, though neither can have a great enough impact on overall GDP to move the needle.
So, while both strategies are directionally correct, neither has created a solution that addresses the true problem of consumer behavior.
