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The Tax Cut Diet and Exercise Program Doesn’t Work

July 14th, 2010 . by economistmom

The first problem with the distinction Republicans are making between the need to offset the cost of extended unemployment benefits (they say “yes”) versus the need to offset the cost of tax cuts for the rich (they say “no”) is that they are mixing up the short-term fiscal policy goal of stimulating aggregate demand with the longer-term fiscal policy goal of encouraging aggregate supply.

But then there’s the issue of how great these tax cuts for the rich actually are (I mean, besides for the rich), even for encouraging aggregate supply over the longer run.  Today Bruce Bartlett reminds us that there’s a wealth of evidence that tax cuts don’t work well as a “diet” to “starve the beast” of government spending.  And the literature also shows that they don’t work that well as an “exercise” program to build up those major “supply-side” muscles in our economy:  labor supply and saving– especially not when deficit financing acts as the public sector’s counter-drag on national saving.  (One example of that latter literature, which I’m sure Bruce has gathered in many other places at other times (including in his latest book), is this 2004 piece by Bill Gale and departing OMB director Peter Orszag.)

And to be fair, when the economy comes out of its current slump and is back to “full employment,” I’m sure Democrats will be saying things that suggest that their favored deficit-financed stimulus policies (which are indeed very effective at stimulating aggregate demand immediately) are also the best things for the longer term, doing their own flip-side version of mixing up the short-term economic goals with the longer-term ones.

8 Responses to “The Tax Cut Diet and Exercise Program Doesn’t Work”

  1. comment number 1 by: VAT Brat

    Economistmom,

    Republicans want to cut overall spending–period, FULL STOP. If you understood that, then there you would not be writing about a “mixing up” of short-term and long-term policy goals. There’s no mix up. It’s fully logical and consistent.

    I know that Bruce and you want the Republicans to cave in to the Democrat spending agenda and simply cry Uncle and raise taxes to reduce the deficit. I don’t think they’ll do that. They’d prefer to see expenditures for interest on the debt crowd out expenditures on entitlement programs and let the Democrats take the responsibility for trying to raise taxes to pay for them.

    Can you cite any literature that proves that raising taxes and raising government expenditures build up those major supply-side muscles in our economy? If you don’t, then I don’t see what you propose to offer to Republicans to change their minds?

    If you want Republicans to raise taxes, then the Democrats have to offer a deal that permanently reduces entitlement spending, and probably repeals Obamacare. Republicans are not stupid enough to believe that merely raising taxes will restore fiscal responsibility.

    Remember that the “Clinton surpluses” occured during Republican control of Congress, and largely as a result of the Bush 41 tax increases.

  2. comment number 2 by: Arne

    Can you cite any literature that proves that raising taxes and raising government expenditures build up those major supply-side muscles in our economy?

    Consider a Laffer-like curve for government spending versus business growth. At zero government spending businesses grind to a halt without roads, utilities, safe workers, etc. At 100 percent, there is nothing left for business. So you have an inverted U with some optimal level of government spending.

    If we are anywhere near the optimum, then the slope of this curve is zero; a small change will have no impact. You should expect to find that there is not statistically significant results to show improvement for either raising or lowering taxes/expenditures.

    Finding blogs that ‘prove’ raising taxes builds the economy is not hard. Convincing ‘literature’ is not so likely.

  3. comment number 3 by: AMTbuff

    Yes, there is definitely an analog of the Laffer curve for government spending. The optimum is somewhere between 0% and 100% of GDP. However the domain is multi-dimensional. For some types of spending the optimum is very low, even zero. For other types of spending the optimum is very hard to define.

    For example, defense spending depends on the threat, and the threat depends on the time frame. If there is a severe short-term threat, the optimum level of spending can exceed 100% of GDP. If the threat is only long-term, it’s difficult to determine an optimum level of spending.

    The domain of the Laffer curve for taxation is also multi-dimensional. Different elasticities apply to different situations, so each needs its own dimension. Capital gains realization is very elastic, as is earned income at the very high end. The Laffer curve peak in those dimensions is relatively low. Middle income wages are not very elastic (except for those very near retirement), so the Laffer curve peak in that dimension is high.

    All this is too complex even for math-crazy academic economists to model. The models are oversimplified, so the results need to be discounted accordingly.

  4. comment number 4 by: Taxnspend

    I think VatBrat meant would raising taxes and increasing government spending above their current levels build up supply side muscle, not from a state of anarchy.

  5. comment number 5 by: BillSmith

    When people expect taxes to go up they change their investments. For instance, instead of rolling a real estate investment (Starker Exchange) clients are paying the taxes today at lower rates and not reinvesting the proceeds.

  6. comment number 6 by: VAT Brat

    Here’s an idea for stimulating aggregate demand that I haven’t heard mentioned by Paul Krugman. Instead of laying off teachers and increasing class size, let’s cut the average pay of teachers (and/or lay off non-teaching staff) so that class sizes aren’t reduced, more people are employed, and less unemployment insurance is paid.

    You’d expect a teacher earning $45,000/yr. to have a higher consumption multiplier effect than a teacher earning $60,000/yr. who would presumably save a higher percentage of their salary. Isn’t that a proposal the Keynesian community should be embracing?

    Like Obama said, “Spread the wealth.”

  7. comment number 7 by: AMTbuff

    Here’s my 5-step program for solving both long and short term problems.

    1. Break the long-term promises NOW: Medicare, SS, Medicaid, Obamacare. Not just a Ryan-style set of target, but specific policy changes and benefit cuts. Break all the promises and show how the scaled-back programs are clearly sustainable.

    2. Endure a protracted general strike by unionized government employees.

    3. Don’t back down. Wait for the counter-demonstrations by fiscally responsible Americans. This is where we show that we are not France or Greece.

    4. Once the young people (who have the most to gain or lose) are on board with the changes, declare victory on spending and begin looking at tax increases like a VAT. Avoid counter-productive policies like 90% tax rates nobody actually pays.

    5. Sit back and watch the economy boom as it hasn’t for decades.

  8. comment number 8 by: Arne

    Cutting back hours and pay together is common in many industries. Even though there are standards for hours of instruction to receive diplomas, it is one of the tools being used to balance school district budgets.