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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.