Will Tax Rate Cuts Completely Pay for Themselves With Increased Revenue?

Includes: UDN, UUP
by: Bob McTeer

The Fed’s lending and the Treasury’s investments in banks will not cost taxpayers anything. Unfortunately, that can’t be said for the government’s stimulus program to create jobs. The stimulus program is old fashioned government spending: Money spent, money gone.

A large stimulus program was needed to cushion the recession and reduce job losses. But the program outsourced to the firm of Reid and Pelosi was not well designed for that purpose. It was too scattershot and not focused, like shooting wild hogs with a shotgun, rather than a high powered rifle — with a laser beam.

I agree with the critics, that the stimulus program was not as effective as it could have been. It was not as effective as China’s, for example. But many critics go too far when they claim that the program hasn’t helped at all — that it has created no jobs at all.

They base that absurd conclusion on the fact that unemployment kept rising, to 10 percent, rather than the 8 percent estimated by the administration if the stimulus bill passed.

The two relevant questions to ask are:

  1. How much higher would unemployment have gone without the stimulus bill?
  2. Did we get enough bang for our bucks? Was it worth the high cost in deficits and debt?

I think stimulus worked, sort of, but not very well, especially considering its budget legacy. Much of the populist anger is based on the sharp rise in the budget deficit, which they associate with the bailouts. The deficits are too large — way too large — and must be reduced for our long-run health.

However, abrupt tax increases to reduce the deficit soon would be a mistake. They would tank the economy and might make the deficit even larger. You see, in addition to increased spending, much of the deficit is resulting from the decrease in tax revenues due to the recession.

The normal condition was for government spending to total 20 percent of GDP, with tax revenue about 19 percent. Government spending is now headed for 25 percent, with tax receipts heading for 15 percent.

So, to the extent that targeted spending programs can spur recovery in the economy, tax revenues will rise as well, and theoretically, at least, can limit the budget deficit. Probably not enough to balance the budget, but enough to suppress the deficit.

What I just said is a cardinal sin in the eyes of my supply side friends. I stated a simple version of the Keynesian notion that government spending (or pump priming) can stimulate the economy and at least partially pay for itself.

The supply side argument emphasizes increasing tax revenue by reducing marginal tax rates. I agree that the right kind of marginal tax-rate cuts would stimulate the economy and increase tax revenues.

But, at current tax-rate levels, I doubt that the tax rate cuts would completely pay for themselves with increased revenue.

Note the parallelism here:

The Keynesian pump priming through government spending will stimulate the economy, but probably not so much as to pay for itself.

The Art Laffer/Larry Kudlow supply-side tax cuts will likewise stimulate the economy and tax revenue, but, in my opinion, not enough to completely pay for themselves. I think the Laffer-curve effect only works completely when marginal tax rates are higher than they are now. Exceptions might be the US corporate tax rate, which is the second highest in the world, and, perhaps the capital gains tax rate.

What these two taxes have in common is an ability of their payers to adjust their circumstances, either by relocating abroad or by timing the realization of capital gains.

Given the choice of stimulating a recessionary economy by more government spending or lower marginal tax rates, I tend to favor the latter. But, acknowledging the efficacy of both gets economists in trouble.

Supply-siders think the Keynesian emphasis on government spending borders on socialism, while Keynesians regard supply-side economics as voodoo and supply-siders as Charlatans.

Each camp tries to remain ideologically pure, which has produced the absurd result that to stimulate the economy, economists and recovering economists like me can’t even decide whether tax cuts, tax increases, and/or spending increases or cuts would be the better choice.

And many in the debate with strong opinions don’t necessarily realize the ideological origins of their arguments. Keynes is the author of the “defunct economist” phrase in my title. The full quote is this:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

One way to characterize the problem is all or nothing thinking. I suggest that policymakers use a dial that can be adjusted rather than a switch which can only be on or off.

We have a huge fiscal mess to deal with–but not too soon, lest we tank the economy as they did by raising taxes in the middle of the Great Depression.

We need a stronger dollar in the long run to support our standard of living, but not too soon. We need a more competitive dollar to support weak demand.

I feel about deficits and dollars like St. Augustine felt about chastity.

You remember his famous prayer: “Lord, make me chaste, but not just yet.”

We must overcome our culture of debt, which made our institutions, including our households, too vulnerable to financial shocks.

I have memorialized our attitude towards debt with a little rhyme:

My house is under water, for sure. My car is upside down, you bet. But I’m getting me a consolidation loan. And finally getting out of debt.

Oh, my title was originally going to be: 'Purity, Obscurity and the Slaves of Defunct Economists.'

On ideological purity, I learned from Ogden Nash that “Purity is obscurity.”

Like Mae West, I was pure as the driven snow.

But I drifted.

Disclosure: No positions