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Posted by on Feb 11, 2009 in Economy, Politics | 24 comments

How Tax Cuts Could Backfire

For a little light on the hot topic of the day, the final shape of the stimulus bill, here is an expert view under the title of “Can Tax Cuts Deepen the Recession?”

A new paper by Gauti Eggertsson of the New York Fed argues that tax cuts will lead to increases in both supply and demand, failing to close the gap between the two.

“Under normal circumstances,” notes the Times‘ Freakonomics blog, “this doesn’t present a problem, because the Fed can lower interest rates to close this output gap. But right now, the Fed has set interest rates as low as they can go, and so different principles apply. Eggertsson’s concern is that a big output gap will lead inflation to fall, leading real interest rates to rise in the middle of the recession.

“These higher real interest rates further dampen economic activity, and with the Fed powerless to offset this, there’s the very real risk of a deflationary spiral. And so a tax-cut-based fiscal stimulus might actually backfire. In fact, Eggertsson reckons there’s a chance that tax cuts could even deepen the recession.”

As Republicans keep repeating their mantra of putting money into the taxpayers’ pockets, Democratic negotiators might try to slip some rational arguments into the discussion. Eggertsson’s theory has no historical data to validate it, but it seems to make sense–if that has any place in the deliberations.

Cross-posted from my blog.

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Copyright 2009 The Moderate Voice
  • CStanley

    I have a very hard time believing that he’s correctly predicting the change in labor supply based on a tax cut. If tax rates remain higher, are people really likely to refuse employment or work less? There just doesn’t seem to be much potential fluctuation there.

  • StockBoySF

    Taxes fund government spending on infrastructure and government spending on infrastructure produces jobs. If we reduce taxes then we either go without infrastructure spending (or reduced) or we fund necessary infrastructure projects by running deficits. Right now people need jobs and while tax reductions may encourage a nominal amount of private job creation, private industry does not invest in public infrastructure projects.

    It’s best to use government money to directly create jobs, rather than hope for some trickle down effect. Also the added benefit of people having jobs is that they are not collecting unemployment benefits.

    So for anyone who wants tax cuts and not direct government spending, I ask you, “Who will pay for the required infrastructure projects?” We’ve already seen one major bridge collapse in a major metropolitan area (the I-35 bridge between Mpls/St. Paul). How many more bridges must collapse, levees break (even without hurricanes), roads with potholes, sewers need repairing, etc. do we need before the country realizes that aging infrastructure is a big problem?

    Tax cuts, even though we all like more money in our pockets, are not the solution for this ailing economy. It wasn’t even the solution when the economy was doing “just OK” under Bush.

  • CStanley

    Stockboy, if there is any consensus at all among economists, it seems to be forming around the combination of doing both tax cuts and spending for job creation. The tax cuts if done properly can actually be much quicker because they could immediately change the payroll deductions or mail out rebate/stimulus checks. Now, it’s questionable whether or not any of that will help since many people right now are going to be averse to spending even if they get a bit more cash in their pockets, but that’s the concept anyway (instigating more consumer spending to increase demand, not trickle down of jobs- though some corporate tax changes can help preserve jobs, or possibly create a small number.)

    Hardly anyone wants to forego doing infrastructure stuff though, so that’s pretty much a strawman argument. I do think that a lot of people overestimate how much that can help since even shovel ready jobs take time, and it’s not as though unemployed roofers can switch gears to build roads and bridges. But most people know that our infrastructure is aging and we need to do a lot of those jobs anyway, so even if it’s not directly affecting the downward recessionary spiral the way this is meant to, there’s not a lot of opposition to doing it.

    The bottom line is that no one (including govt) can really just ‘make jobs’ that easily or rapidly- and if it tries to do so then there’s an artificial manipulation which has unintended effects too because those jobs are subsidized and won’t be long term if the products or services being produced are not matched by demand. Same with the private sector- no one is going to hire people if there aren’t any customers.

    • StockBoySF

      CStanley, I agree with many of your points, including that it may tkae some time for these jobs to be up and running.

      As far as your statement, “Hardly anyone wants to forego doing infrastructure stuff though, so that’s pretty much a strawman argument.” What about the Republican Senators who want tax cuts and less spending? The thing about (pork) spending is one man’s view that something is wsteful is another man’s job. In this WaPo article many states were hoping for the House version of the bill to pass because the provisions taken out to win over a couple Republican Senators cut state funding- and jobs.

      http://www.washingtonpost.com/wp-dyn/content/article/2009/02/10/AR2009021003916.html

      So I disagree with your assessment that “harldy anyone “anyone wants to forego doing infrastructure stuff” when most of teh Republicans in Congress want to cut some of those very projects (and other projects which woudl keep people employed). Funny how the Republicans, when they were in charge wasted so much money on pork, including that “$250 million bridge to nowhere” (which ultimately did not go through, though Alaska did receive the money and spent it elsewhere) and now that projects are identified which can keep people from losing their jobs the GOPers say, “No. It’s just waste.” What they really mean is this, “Most of those jobs are in Democratic states and we don’t think money should be rewarded to Obama’s supporters.” Even though we’re talking about tehh average workers about to lose their job (and not liek it was after the 2000 and 2004 elections when the wealthy Big Oil supporters who had jobs and who just wanted more money were rewarded for supporting Bush).

  • BBQ

    Could we stop citing the I-35 bridge for examples of our crumbling infrastructure, it was a design flaw and the additional weight from maintenance. That isn’t because it was neglected all those years. Granted I used to work for WI DoT and do know that we need major updates but every bridge in this country isn’t going to fall down tomorrow.

    • StockBoySF

      BBQ: I don’t much care why the I-35 bridge fell down. The I-35 bridge needed to be repaired for whatever reason, and money was needed to repair it. The point is stuff happens and money needs to be spent.

  • CStanley

    What about the Republican Senators who want tax cuts and less spending?

    Did any of them say they were categorically against increased infrastructure spending (through the normal budget process) or was it just that they didn’t see it as appropriate for an emergency stimulus package?

    To me, and a lot of other conservatives, the point about the infrastructure spending is that it should be done according to priority, not according to seniority (ahem, Mr. Byrd.) That’s half the problem with the earmark/ pork stuff. The other half is that there’s not only insuffiicent attention paid to a distribution of federal funds according to highest need, but also a tendency for the earmarked stuff to be political payback and vote buying instead of truly needed projects.

    The thing about (pork) spending is one man’s view that something is wsteful is another man’s job. Fine, but if there’s a legitimate need then it should be able to stand up to scrutiny of open debate. Again, that gets back to the prioritization. Why should one senior Congressman get to create some jobs in his district while others with more pressing needs are passed over? Resources are finite and should be allocated according to highest need, not by political clout.

  • Dr J

    If you believe that any spending is good spending for the purposes of jump-starting the economy–and perhaps it is–then a pork-filled stimulus package is as good as any other.

    But how can you then claim tax cuts are counterproductive? Is the theory that any spending is good spending, so long as it’s a government committee rather than taxpayers doing the spending?

  • StockBoySF

    CStanley: “Why should one senior Congressman get to create some jobs in his district while others with more pressing needs are passed over? Resources are finite and should be allocated according to highest need, not by political clout.”

    Well if the Republican representatives don’t put forth stimulus ideas for their districts then no one else will.

  • StockBoySF

    Dr_J: “But how can you then claim tax cuts are counterproductive? Is the theory that any spending is good spending, so long as it’s a government committee rather than taxpayers doing the spending?”

    Well the government has to pay for its spending. And at this point many people would rather pay down debt (especially if they are afraid of losing their jobs) than spend money on new stuff. A lot of people are cutting back in these uncertain times. If they knew they could rely upon their income for the next few years, then they’d go out and spend.

  • CStanley

    Great process, Stockboy- everyone needs to quickly grab what they can, and damned the consequences for those who don’t. I’m sure that’s how the founders intended for our legislative process to work.

    Well the government has to pay for its spending. And at this point many people would rather pay down debt (especially if they are afraid of losing their jobs) than spend money on new stuff. A lot of people are cutting back in these uncertain times. If they knew they could rely upon their income for the next few years, then they’d go out and spend.But the job creation/spending part of the bill is just as dubious, and that’s the point. Some people aren’t willing to scrutinize that (whether or not this massive expenditure actually has a net positive effect, when even the CBO says probably not) because they say that the CW is that public spending has a positive effect in a recession. That’s an unproven dogmatic belief, just as likely to be untrue as the dogma that tax cuts always help to increase consumer spending and aggregate demand.

  • Dr J

    StockBoy: “many people would rather pay down debt (especially if they are afraid of losing their jobs) than spend money on new stuff.”

    Of course, but doesn’t that sound like a fantastic idea? They pay down debt to banks, the banks lend the money out, someone spends it. The CDOs and whatnot that debt backs get more solid, the whole finance sector gets a little healthier. This *entire mess* has been–and still is–fundamentally a matter of large numbers of individuals over their heads in debt.

  • CStanley

    That is a very good point, Dr_J. I am pretty sure we’re in uncharted territory here in terms of the amount of consumer debt- so I don’t think anyone knows (or is even trying to predict) how a wealth transfer to individuals will affect the economy if the money is used for debt repayment instead of purchasing. Isn’t it possible that along with easing the household budget and balance sheet that these types of payments could also help stimulate economic activity (because debt repayment too, gets money flowing again?)

  • rudi

    Please stop – our tax burden is near the lowest of all Western economies. Google “Forbes misery index” to see that were not being taxed to death.
    http://www.forbes.com/global/2008/0407/060_2.html
    Pentagon spending is killing us. The US defense spending is half of the world total. This comment at Forbes link nails it:

    I think the real flaw with this story is that it doesn’t take into consideration what citizens of more “miserable” countries are getting for their tax dollars: free healthcare, subsidized child care [More]

  • CStanley

    Actually, Rudi, I thought another comment there was more apt:

    The index is somewhat flawed, in that it doesn’t take “deferred taxes” into account.

    The US is rapidly forcing itself into a corner with it’s reckless “borrow and spend” government’s policies.

    Once circumstances force us into adopting a pay-as-you-go level of fiscal responsibility, I think the pain will be great indeed — requiring both drastically reduced government expenditures AND a much higher tax burden to redress the balance.

  • rudi

    Cs – While comment is apt, I address the meme about the US being over taxed. Our tax rate is the lowest of the G8, how much lower can we go? All those countries have single payer health costs, without the large defense expenditures. The dems play lip service to PAYGO, the repugs not…

    • Dr J

      Rudi, I would hope we can go a good deal lower, if the alternative is taxing and spending on daft policies like a single payer health system

  • CStanley

    Yeah, that’s rather bizarre logic, Rudi. It’s called a misery index for a reason, and being near the bottom is desirable. I really don’t get the rationale that other countries are even more miserable, and therefore we ought not complain or worry about it. Especially when that approach means we necessarily WILL move up the scale if we continue spending at this rate and then have to raise taxes when the debt level isn’t sustainable.

    And speaking of sustainability, how’s it working out for those highly taxed Europeans? Check out Mikkel’s post and links.

    Oh, and on the defense spending? I’m all for cutting out the massive waste, but overall our defense spending is going to remain high and a big part of the reason is that Europe’s defense spending is so low. They not only have high rates of taxation to support their welfare states, but we subsidize it as well.

  • Dr J

    The misery index also excludes the cost of regulation. Health care regulation alone imposes over $300 billion in costs on, ultimately, us consumers/taxpayers. From http://www.cato.org/pubs/pas/pa527.pdf :

    “The high cost of health services regulation is responsible for more than seven million Americans lacking health insurance, or one in six of the average daily uninsured. Moreover, 4,000 more Americans die every year from costs associated with health services regulation (22,000) than from lack of health insurance (18,000).”

    • rudi

      Moreover, 4,000 more Americans die every year from costs associated with health services regulation (22,000) than from lack of health insurance (18,000).”
      Prove this with a valid link.

      • Dr J

        The link is working fine for me, though there was initially a problem with that last colon sneaking in. If you’re still having trouble, google “health care regulation costs” and it’s the first link.

  • rudi

    Forbes calls it a “misery index”, tell that to those who can’t afford resonabel medical care. Even Mexico has single payer medical care and their “misery index” is lower than ours. Canadians and Scandinavians don’t think their systems foster “misery”.

  • rudi

    Dr_J – This Russell Kirk Center article claims most regulation is for the benefit of Big Business.
    http://www.kirkcenter.org/index.php/bookman/article/behind-the-big-ripoff/

    UB: Briefly, what is the theme of The Big Ripoff?

    TC: Government regulation is often created at the request, and to the benefit, of big business. Enron supported the energy-restricting Kyoto Protocol on climate change. Philip Morris backed federal regulation of tobacco. Boeing, General Electric, and Halliburton all lobby for more government, not less.

    It’s a reporting book, full of under-reported stories, and the economic theme is government intervention in the economy benefits the biggest businesses while hurting consumers, competitors, and taxpayers.

    UB: How does political debate misunderstand the relationship you see between government and business get reflected in political debate?

    TC: Liberals often demand regulation as a way to curb big business, while conservatives often defend business as if that were the same thing as defending the free market. In truth, being “pro-business” often means being pro-regulation, while being pro-free-market is the last thing many big businesses want.

    • Dr J

      Rudi: “This Russell Kirk Center article claims most regulation is for the benefit of Big Business.”

      Certainly government passes regulation or takes any other action at the behest of one interest group or another. Businesses will lobby for measures that suit their interests and oppose those that don’t, just like every other group, and legislation will end up oiling the squeakiest wheel. I’m not a bit surprised.

      The obvious conclusion is we should put limited faith in regulation, because the government is lousy at implementing it in an even-handed way.

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