Saturday, January 19, 2008

Bartlett on Bush's Keynesian "feel-good" tax cuts

Bruce Bartlett, nicely expanding on what I wrote last night about the prospective second round of Bush tax cuts, in this morning's WSJ...

With remarkable speed, Congress, the White House, Republicans, Democrats and even the Federal Reserve have come to a consensus on the need for economic stimulus to moderate and perhaps forestall a recession. It seems certain that the final stimulus package will contain a tax rebate.

The underlying theory for the rebate idea traces back to the British economist John Maynard Keynes. He believed that spending was the driving force in the economy. It didn't matter whether the spending was done by businesses on capital equipment, by governments on public works, or by consumers -- spending is spending in the Keynesian model, and all of it is stimulative.

In Keynes' defense, his theory was developed during a severe, world-wide deflation. Spending of all kinds was paralyzed by a lack of liquidity, and the Federal Reserve had difficulty injecting money into the economy because so many banks had closed. Under these circumstances, deficit spending by governments made sense as a means of getting money into circulation and overcoming deflation. The problem is that, once World War II seemed to validate Keynes's theory, the idea of stimulating the economy by increasing government spending became the all-purpose cure for every economic slowdown, regardless of its underlying cause.

In the 1960s and 1970s, this usually took the form of public works spending. But in 1974, the White House was keen on the idea of cutting taxes to stimulate private spending. Since it was feared that a permanent tax cut might be inflationary, President Gerald Ford and the Democratic Congress agreed on a one-shot tax rebate. It was thought that cash-strapped consumers would take their government checks and immediately run out and spend them on food, clothing and other necessities. This would give the economy a Keynesian boost.

One dissenter was economist Milton Friedman. His research had led him to conclude that consumer spending was less a function of liquidity than something he called "permanent income." Friedman observed that when workers lost their jobs, they didn't immediately cut back on spending. They borrowed or drew down savings to maintain spending, in the expectation of finding a new job shortly. Conversely, consumers didn't immediately spend windfalls. They kept spending on an even keel until they achieved a promotion at work, or other increase in their long-term income expectations.

Thus Friedman predicted that the $100 to $200 checks disbursed by the Treasury Department in the spring of 1975 would have a minimal impact on spending, because they did not alter peoples' permanent income. Most likely, people would save the money or pay down debt, which is the same thing. Very little of the rebate would cause consumers to buy things they wouldn't otherwise have bought in the near term.

Subsequent studies by MIT economists Franco Modigliani and Charles Steindel, and Alan Blinder of Princeton, showed that Friedman's prediction was correct. The 1975 rebate had very little impact on spending and much less than a permanent tax cut -- which would change peoples' concept of their permanent income -- of similar magnitude.

In 2001 -- despite the thoroughness and general acceptance of these studies -- Congress and the White House once again chose a one-shot tax rebate to deal with an economic slowdown in 2001.

To his credit, Treasury Secretary Paul O'Neill cautioned against the rebate. "I was here when we tried that in 1975, and it just didn't work," he said. "If we want to change consumption patterns, we need to make permanent changes in peoples' tax burdens." But President George W. Bush overruled his Treasury secretary and approved the rebate idea. Checks of $300 to $600 per taxpayer were sent out in the late summer. Contemporaneous polls by Gallup, Bloomberg and the University of Michigan all found that the vast bulk of consumers expected to save the money or use it to pay bills. Subsequent studies confirmed these forecasts.

In short, there is virtually no empirical evidence that tax rebates are an effective response to economic slowdowns. The increased personal saving doesn't help the economy because the federal budget deficit, which can be thought of as negative saving, offsets all of it in the aggregate. The main benefit of a tax rebate would seem to be political -- giving politicians a way of appearing to be doing something about the nation's economic problems that is superficially plausible.

A new rebate probably won't do much harm. But anyone who thinks it will prevent a recession -- if one is actually in the pipeline, which is not at all certain -- is dreaming. It's an insult to Keynes even to call a tax rebate Keynesian economics. It should be called "feel good economics" because its only real effect is to make politicians feel good about themselves and buy re-election with the public purse.


At January 19, 2008 at 10:58 AM , Blogger Bryce Raley said...

I'm not an economist but isn't the normal business cycle 4-6 years of growth with a couple years of contraction.

Is it normal to have all ups and no downs with artificial controls and monetary policies?


I would love for you to weigh in on the macro side here.
I've had two years of economics in business school and just remember key concepts.
Isn't savings a key component of GDP. What if tax cuts were given and people saved money? Wouldn't this help our GDP? All the focus is on spending. I don't understand and don't claim too.

At January 19, 2008 at 11:39 AM , Blogger Eric Schansberg said...

There is no (firm) time frame to put on the length of a business cycle. Yes, it is normal to have ups and downs within the macro-economy as markets correct themselves.

Beyond that, there is (significant) debate within the profession about the ability (in theory and in practice) of policymakers to manipulate the business cycle-- in particular, to reduce the length and depth of recessions.

Generally, fiscal policy is not preferred to monetary policy-- because it is slower and more unwieldy. The policymaker must recognize the problem (small advantage to monetary policy), implement a solution (big advantage to monetary), and see the solution impact the economy (significant advantage to monetary).

In this case, as "quick" as Congress and the President might act, it will still take months for the impact of the policy to be felt. And by then, it may simply make things worse-- even if it was able to affect the economy significantly.

But fiscal policy may have *political* benefits, so...

And all of this is ignoring the clear benefits of a Supply-Side tax cut as opposed to a Keynesian tax cut. But the former is more about long-term economic growth than short-term help with the business cycle.

To your last question, savings is as important as consumption. But the money is still coming from somewhere-- and here, probably from future taxpayers (who will able to consume and save less)!

At January 19, 2008 at 12:24 PM , Blogger Bryce Raley said...

I agree that the knee jerk short-term solutions don't make much sense and would probably hurt more than help.

The supply side makes so much sense. What incentives are there to save or produce when we tax so much of our productivity? I don't believe anyone has denied the fact that the Bush tax cuts increased tax revenues in a big way.

What are your thoughts about the long term affects of low to no savings by individuals or governments on the global economy?

Also, what about the affect of unbacked flat currencies like the dollar?

I have read some of businessman Peter J Daniels publications.
He is one of the wealthiest men in Australia, and a bible believing Christian. He started moving most of his real estate fortune (which he hasn't given away) into gold and silver backed securities during the early 2000's. He even owns a bullion banking operation. He has a bleak outlook on global economics. I am such a novice, but his stuff is very interesting. I heard him speak in 2001 about the economic problems the US and Australia would have when Japan and China started cooperating. He said they would become the largest economic and military superpower the world had ever seen. He said we should stop sitting back complacently.

Any thoughts?

At January 19, 2008 at 1:18 PM , Blogger Eric Schansberg said...

Bush's tax cuts had very little in terms of Supply Side (compared to JFK and Reagan)-- and less than they should have been given his desire to insert Keynesian tax cuts as a substitute.

I'm not an expert on savings, macro, etc.-- so I don't feel qualified to comment at any length on that. One thing I would say: govt programs like SS will lower private savings rates.

A fiat currency allows for more shenanigans on the part of those who control the money. De facto, such shenanigans are limited in a market economy, because the market will police misbehavior to a significant extent.

At January 19, 2008 at 10:50 PM , Anonymous Anonymous said...

This is the problem with a tax system that is highly manipulable, subject to influence and continual revision by lobbyists and politicians, taxes business resources and payroll which cannot be extracted from exports and results in higher "price tags" for consumers.

Clearly, the answer is in front of us - the FAIRTAX (that's right, the same plan demagogued by Mr. Bartlett), and the research bears this out:

The FairTax rate of 23 percent on a total taxable consumption base of $11.244 trillion will generate $2.586 trillion dollars – $358 billion more than the taxes it replaces. [BHKPT]

The FairTax has the broadest base and the lowest rate of any single-rate tax reform plan. [THBP]

Real wages are 10.3 percent, 9.5 percent, and 9.2 percent higher in years 1, 10, and 25, respectively than would otherwise be the case. [THBNP]

The economy as measured by GDP is 2.4 percent higher in the first year and 11.3 percent higher by the 10th year than it would otherwise be. [ALM]

Consumption benefits [ALM]:

• Disposable personal income is higher than if the current tax system remains in place: 1.7 percent in year 1, 8.7 percent in year 5, and 11.8 percent in year 10.

• Consumption increases by 2.4 percent more in the first year, which grows to 11.7 percent more by the tenth year than it would be if the current system were to remain in place.

• The increase in consumption is fueled by the 1.7 percent increase in disposable (after-tax) personal income that accompanies the rise in incomes from capital and labor once the FairTax is enacted.

• By the 10th year, consumption increases by 11.7 percent over what it would be if the current tax system remained in place, and disposable income is up by 11.8 percent.

Over time, the FairTax benefits all income groups. Of 42 household types (classified by income, marital status, age), all have lower average remaining lifetime tax rates under the FairTax than they would experience under the current tax system. [KR]

Implementing the FairTax at a 23 percent rate gives the poorest members of the generation born in 1990 a 13.5 percent improvement in economic well-being; their middle class and rich contemporaries experience a 5 percent and 2 percent improvement, respectively. [JK]

Based on standard measures of tax burden, the FairTax is more progressive than the individual income tax, payroll tax, and the corporate income tax. [THBPN]

Charitable giving increases by $2.1 billion (about 1 percent) in the first year over what it would be if the current system remained in place, by 2.4 percent in year 10, and by 5 percent in year 20. [THPDB]

On average, states could cut their sales tax rates by more than half, or 3.2 percentage points from 5.4 to 2.2 percent, if they conformed their state sales tax bases to the FairTax base. [TBJ]

The FairTax provides the equivalent of a supercharged mortgage interest deduction, reducing the true cost of buying a home by 19 percent. [WM]

ALERT: Kotlikoff refutes Bruce Bartlett's shabby critiques of the FairTax.

At January 19, 2008 at 11:11 PM , Blogger Eric Schansberg said...

Uhhh, thanks Ian-- I guess...that's quite a tangent to pursue!

The Fair Tax is a very important policy issue, but unrelated to this posting (at least directly). To bring it back to the topic at hand (how to cut taxes to stimulate an economy), note that if politicians think there is a recession and want to take credit for trying to fix it, it'd be just as easy for them to cut a Fair Tax rate. Arguably, such a tax cut would be worse than a Keynesian tax cut, since consumption rather than consumption and investment would be encouraged. And again, compared to a supply-side tax cut, nothing would be done to directly stimulate production.

Politically, I am eager to see either a Fair Tax or a Flat Income Tax. I have blogged on the Fair Tax and will do so again soon!


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