Economic benefits of major tax cuts: explaining the myth

I never thought I would say this, but I am loving me econ class right now. The topic we are discussing in class right now is fiscal policy. Being a democrat, I always felt like big tax cuts and less government spending was not the best answer to reducing our deficit, but now I feel like I actually have a proven, statistical reason to support my "hunch."

I've learned that there are two major actions the government can take to boost spending or "jump start" the economy. It can either enact tax cuts (supply-side economics) or increase spending (demand-side economics).  However, according to my econ book, tax cuts will always have less of an impact than increasing governmental spending, because tax cuts indirectly affect the economy (b/c this affects people's income, and people most likely won't spend their complete income - some of it hopefully goes to savings. This does not affect GDP).  Governmental spending, on the other hand, is a direct injection of money into the economy resulting in increased demand, and increased GDP.

I think that reasoning is right. =/ If I explained this wrong, please help me!

Our optional reading included an article by Alan Murray, "'Dynamic' Scoring Ends Debate on Taxes, Revenue" (from 2003!). Now this article broke it DOWN.

It explained why so many people were arguing that tax cuts will be majorly beneficial to the economy (even though basic economics, as I just explained, already knows it isn't). There was this guy, Art Laffer, who met with Dick Cheney and Donald Rumsfeld in 1974 and "sketched a curve on a cocktail napkin suggesting that a cut in income taxes could provide such a spark to the economy that government revenues would rise, not fall" (Murray). This graph, however, did not have any numbers on either axes. Murray does a really nice summary of the debacle, but it comes down to this: the Congressional Budget Office (CBO) did an extensive study and used dynamic scoring (which was invented to figure out the "numbers" for the graph), but unfortunately those "numbers" did not prove anything. 

Murray says, "using some models, the plan would reduce the budget deficit from what it otherwise would have been; using others, it would widen the deficit. But in every case, the effects are relatively small. And in no case does Mr. Bush's tax cut come close to paying for itself over the next 10 years."

On top of that, the two "models" that did show an improvement in the deficit as a result of the supply side (tax cut) strategy were models that assumed "that after 2013, taxes would be raised to eliminate the remaining deficit."

His conclusion:
"Certainly, tax cuts can improve overall economic growth. And certainly, revenues may rise as a result. But at current levels of taxation, those effects are relatively small. There is no free lunch."

My conclusion
So, if we care about reducing the deficit, it looks like at some point we will have to start PAYING TAXES.

Early Retirement Extreme : Jacob Lund Fisker

Jacob has put together an extremely well written blog detailing his path to achieving early retirement at an accelerated pace.  You should browse his writings here at Early Retirement Extreme -The choice nobody ever told you about.  Here is a short synopsis:  Jacob got his PhD in Theoretical Physics by the age of 25, and then worked for 5 years in the US.  During this time, he saved upwards of 75% of his income, and invested it wisely (though not necessarily with great success)  At the age of 30 he was done with the rat race, and by 33 he had completely retired.  Some of his suggestions (like eating frugally, basically eating only one type of canned food) are very extreme, but then that is the entire thesis of his blog.  He has several other suggestions on frugal living, some of which I agree with, and several that I do not.  Jacob also does not have any kids, so that makes his situation very different from mine.  I think planning to retire early, when one has kids to take care off and raise poses some unique challenges that he wouldn't be aware off.  Finally his current lifestyle seems to be a little on the "edge", with a high risk medical insurance strategy, and extreme frugal living

In any case, his determination is what makes his early retirement possible, and there is a lesson to be learned there.  On the other hand, I postulate that his extreme approach is not necessary in the India context.  Our environment in India allows for a moderate lifestyle without incurring significant expenses.  I will try to provide some insight into how we plan to achieve similar savings goals as Jacob, without necessarily living a life as frugal as he did/does.

Early Retirement : Safe Withdrawal Rate (SWR)

Safe Withdrawal Rate or SWR, in the context of retirement (early or otherwise), was a term coined by William Bengen.  Bill wrote about SWR in the Journal of Financial Planning in October 1994.  He proposed that once you have accumulated your retirement corpus, you should withdraw only 4% of the corpus for your expenses on a yearly basis (adjusted for inflation of course).  As long as you maintain the 4% withdrawal rate, you will never run out of money throughout your retirement years.  If you increase your withdrawal rate to 5%, you have a high probability that your money will run out before you die. 

This is a very fundamental thought that every retiree has to go through.  How much can I afford to withdraw every year for my living expenses?  If I withdraw too much, I run the risk of running out of money soon.  If I withdraw too little, I am forcing myself to live a more frugal lifestyle than I can afford, and will not be able to live my retired years to their fullest potential. 

Bill based his analysis on historical return rates of stocks and bonds, and looked at real scenarios over the last 75 years.  He analyzed different withdrawal rates, and back tested the probability of your initial retirement corpus running out, across various time-frames over the last 75 years to prove his hypothesis.  This is a seminal piece of work, and if you have the interest, you should read the original article by William Bengen. 

Amazingly enough, financial planners in India, almost never quote or even refer to Safe Withdrawal Rates.  The entire concept seems to be alien to wealth managers here.  Typically a simple mathematical formula assuming a 6% or 8% inflation rate is used to figure out how your expenses in retirement will increase.  The effect of compounding is then typically used to frighten the lay person with the large numbers that invariably result from the long 30-40year retirement scenarios.  Finally a 12-15% rate of return is assumed on your invested corpus to figure out how long your corpus will last, or how much you will need to save up to last through your retirement years.

Of course the SWR will vary from country to country based on the historical data, current inflation scenario, future GDP growth prospects etc.  Currently financial planners in India seem to take these into account in a ad hoc manner, and are in general oblivious to SWR in the Indian context.

I recently came across a study done in Japan, that attempts to determine the SWR in emerging markets.  I have contacted the authors to understand their thesis a little better, and seek permission from them to share their results with you. 

In the meantime, I will publish a couple of more articles describing how SWR works in the coming days, with some examples and illustrations.

Early Retirement : Philip Greenspun

Who the heck is Philip Greenspun?  Well Phil has a PhD from MIT, has started several successful businesses, seems like an extremely articulate and witty guy, has his pilots license, and most importantly retired at the young age of 37.  If you'd like to read up more about him, here is where you go: Philip Greenspun on Early Retirement

Retire Early and Travel

Now that I have become "more involved" with my retire early planning, I have come across a lot of material out there, about people who have already trudged this path and taken the plunge.  I love reading about these "case-studies" as it helps to fine tune my own thinking.  One more such example is about Warren and Betsy, the folks at Married with Luggage.  They have retired at the age of 40, and plan to travel around the world.  They also document all their expenses here.  I think the learning for me here is (1) It is important to make a plan and then put in all my energies to execute to it (2) It pays to be methodical, particularly when it comes to documenting expenses (3) It helps to be internet web savvy.  You can churn out a lot of good material, if you are very comfortable with the medium. 

Early Retirement : Monthly Income Sources

I am very interested in developing passive income sources to meet my monthly expense needs.  Currently we are stuck in the economic rat race, with all of our monthly income coming in from our salaries.  We have no other sources of income (other than some small interest earnings from our savings bank accounts; which I actively try to minimize, since I am not interested in accumulating any debt income)  We also get some dividend income from stocks, but that is too small at this time to make any significant impact to our overall income profile.  We do not have any rental income either.  So my Oct'2011 snapshot of monthly income sources, looks as follows:

Now this is a pretty depressing picture to look at from an early retirement perspective.  Ideally I want the bulk of my monthly income coming in from non-salary sources.  At this time we are 100% locked in to our jobs since we are completely dependent on our salaries for monthly expenses.  Over time, I will need to come up with additional income sources to first supplement, and then replace our current salary based monthly income.

Household Savings Rate

Earlier this month I had stated my intent of saving 85% of our family take home income.  I am still unsure if I can achieve this aggressive savings rate, but I am pretty sure that over the last few months, our savings rate should be around the 50%-60% levels.  This got me wondering as to what the average household savings rate is across India/World.  So I went searching for this data, and here is what I dug up from GFMAG.

I have reproduced the following table from the above site here for convenience. 

The shocking statistic for me was that across the world over 2decades of time the annual average household savings rate maxes out at 20%, with the most common savings rate being in the mid to high single digits.  Now of course the need to save could be different in different countries.  Typically countries that have a higher proportion of social security, should have lower savings rate since there is less of a drive to save for a household, as the government is expected to provide support post retirement. 

Though countries like India and China are not listed in this survey, I would assume we would naturally have a much higher savings rate since our government does not provide any kind of social security whatsoever. 

In any case, the fact that the average savings rate is much below my 85% target, gives me a lot of confidence.  On average, people do not retire early, and continue to work into their late 60s.  For me to be able to retire in my 40s, I need to be doing something that is not the average, and I hope my aggressive savings rate will make the difference when compared to the average joe.