Archive for Tuesday, February 17, 2009

What works? Tax cuts or government spending?

February 17, 2009


Today our government basically follows the policies advocated by the famous 20th century economist John Maynard Keynes. In simple words, Keynes believed that the capitalist free market system should be left alone as long as it works but that the government should step in whenever it doesn’t. A hundred thousand houses are an asset for any nation, Keynes wrote, but a million unemployed are a liability. So, when we need houses and have unemployed, why not let them build the houses, even if the government has to hire them to do so?

These days, both Democrats and Republicans seem to agree with this philosophy, but there is a basic difference: Democrats want to put emphasis on increasing direct government expenditures; Republicans want to see more tax cuts so, as they put it, people themselves can decide what to spend their money on. Which is the better policy to mitigate our current economic situation? Let us see.

It is clear that to increase income and employment, money must be spent. One of the most important issues that beginning economics student have to learn is that income equals expenditures. Nobody can spend a penny without someone earning it, and no no one can earn a penny without someone spending it. You may believe that our city, state, or federal government should spend less, and at times you might be right; but what you must realize is that any dollar not spent is a dollar not earned.

Whether that money is spend on street repairs, renovating dilapidated school buildings, or hiring more teachers, it does increase income and employment. And it does not stop there; there is what economists call the multiplier effect. The formerly unemployed who now have an income will pay some of it in taxes, may save some of it and will spend the rest. What they spend will become income to someone else, who again will spend part of it and so increase further income.

But what if the government spends the money on “pork,” on a bridge to nowhere? That is obviously much less desirable than spending it on education, health care, the protection of the environment or other socially desirable endeavors. However, even building a bridge to nowhere does create income and jobs and has the multiplier effect. Keynes argued that even taking half of the unemployed and letting them dig holes in the ground and take the other half and letting them fill the holes up again is better than doing nothing, as long as the goal is to curtail a recession.

So how about tax cuts? Tax cuts, I am afraid, do not accomplish the same, because the recipients of these tax cuts may not spend the money; and the larger the taxpayer’s income and wealth, the lower is what economists call the “marginal propensity to consume,” that part of any additional income that is spent.

Suppose you are financially relatively well off, your house is paid for, you have nice savings, and the annual income for you and your spouse is $1,350,000. Now you get the $800 provided for in our current stimulus package for most taxpayers. By how much will you increase your expenditures? I would say that you probably would not buy anything that you would not have bought anyhow. But give $800 to a poor couple who doesn’t have money to buy enough food and also heat their small apartment adequately, and who may not earn enough to pay taxes anyhow. You bet they’ll spend it all immediately.

But how about investments? Would higher income earner not spend money on investments? Let’s suppose, then, that you are a manufacturer who produces ladies’ dresses and accessories, and because of our current recession your sales have dropped to half and you had to lay off some of your employees. Now you get a $20,000 tax cut. Will you now hire your laid-off workers again if you can’t sell the things you have on hand? Hardly.

You may use the money to pay back a loan you owe to your bank. Banks like to lend out money; after all their income comes from the interest paid on loans. But they will not lend out money these days to people, businesses or institutions that may not be able to repay the loans. So the money you paid to the bank will stay there, it has changed hands only once and the multiplier will is one.

A super conservative, on the other hand, might argue that the government has no business interfering in the economy like that, with huge, uncalled for, unnecessary expenditures because, in the long run, the free market itself, if left alone, will take care of matters by itself. Keynes had an answer to that one also: “In the long run,” he wrote, “we’ll all be dead.”

Harry Shaffer retired last year after 50 years of teaching economics at Kansas University.


Richard Heckler 9 years, 2 months ago

Since 1980 voodoo economics, tax cuts,massive outsorcing and mideast wars have not been producing jobs or robust economies only robust debt. We've been duped.

Isn't it odd each time our nations financial institutions crumble there are Bush family near by and a McCain still in office?

Who has history with financial institutions going south such as the savings and loan scandal? Republicans!

McCain: The Most Reprehensible of the Keating Five. The story of "the Keating Five" has become a scandal rivaling Teapot Dome and Watergate ...

just_another_bozo_on_this_bus 9 years, 2 months ago

"It is entirely built on the false assumption that private spending will not go down as government spending increases."

Is it really false? Or does it just violate your ideological beliefs?

Godot 9 years, 2 months ago

Can any Keynesian point to a time where massively increasing government spending, with accompanying tax increases, worked without leading to totalitarianisim?

Tony Kisner 9 years, 2 months ago

Bozo you need to read Prof Harry's work again, then think about ideology.

The US has already paid people to build houses that now sit empty (digging holes). I guess now we should pay for someone to burn them down (filling them in). Economic value is the issue, if you want to increase cash moving through society just start printing it, no different than digging a hole.

I wish I had tenure.

Brent Garner 9 years, 2 months ago

One of the flaws in the Keynesian model is the apparent assumption that the pass through of the tax dollar in the government intervention side and the pass through of the tax dollar on that tax cut side are equal. They are not. The government is the single most inefficient method of transferring dollars from the taxpayer to any program. Why? Government costs of administration are notoriously high. I have seen estimates that state that anywhere from 28 cents to 40 cents of each tax dollar collected and "spent" by government never reaches the intended program or individual. The reason for this is the cost of all the government employees who oversee/administer these programs. Yes, their salaries do have an economic impact, but they also dilute the economic impact on the public of any "spending" done by the government. Leaving the tax dollar in the pocket of the taxpayer results in a 100% pass through so to speak. Hence, 100% of that dollar is available to be spent and thus it will have a larger economic impact than the other approach. Contrary to claims made above, every time that taxes have been lowered they have been followed with an increase of economic activity. I refer you to the famous Laffer Curve. Yes, there is a point at which further tax reductions actually reduce federal revenues, but, based on historical performance--John F Kennedy, Ronald Reagan, George Bush (2001)--permanent reductions of the tax rates increases economic activity. Interestingly enough, short term tax reductions and "rebates" do not produce long term economic activity--see George Bush(2008). Hence, it is doubtful that the Obama plan will produce much more than a short term uptic in economic activity.

Brent Garner 9 years, 2 months ago

Further, Keynes called for spending during a downturn and taxing during growth to pay off the spending during the downturn. Keynes theory assumes an ideal and rational universe. The real world works differently. Congress, regardless of party in power, has seemed, historically, unable to restrain itself from adding new spending each and every session. Thus we have deficits rising even during times of economic prosperity. The US came close to running a true surplus in the late 90s. However, if you remove Social Security receipts from the overall government revenues--remember social security taxes are allegedly to pay for current and future benefits to retirees not general obligations of the government--then the US has not run a positive balance in decades again regardless of the party in power. Thus, Keynes theory does not work. Frankly what it will take is the personal and national discipline and taking of responsibility to control our out of control spending, live within a true budget, and be honest in our dealings. Then you will see the deficit shrink. You will see sustained economic growth. However, I want it noted that due to my lack of confidence in humans to do this I am not holding my breath.

Chris Ogle 9 years, 2 months ago

What Works? To answer this question; city/county hires a consultant, the state promises but then doesn't pay, the feds create a new department, and the working man just wants everybody to leave him alone and allow him keep half of what he earns.

Trobs 9 years, 2 months ago

What I find ironic is the bias against the free market. The media loves to say the free market didn't work, that's why we're in the crisis. Despite the fact we haven't had a free market in decades. The government has been paying for private companies for a long time.

Despite all of the hands on government we keep coming back to this issue. I think we should avoid any intervention. No tax cuts, no stimulus. Let the economy shed off the dead weight and get back to normal.

I can dream right? The sad reality is that we're going to be dealing with high taxes in a few years to pay off this stimulus.

jonas_opines 9 years, 2 months ago

"Can any Keynesian point to a time where massively increasing government spending, with accompanying tax increases, worked without leading to totalitarianisim?"

Doubtful if we're using your rather loose definition of totalitarianism.

jafs 9 years, 2 months ago


It seem patently clear that the current crisis is due to a lack of government regulation.

The greed and stupidity of many involved is hard to fathom, but created a financial crisis.

If we were to allow the markets to "self-correct", then what happens to all of the unemployed people?

The folks at the top will still come out pretty well, but many low and mid-level employees who may have done nothing wrong will be out of work.

Harry's main point is correct - folks at the lower end of the economic spectrum will spend extra money much more quickly than folks at the top. And, especially right now, banks are not using their assets to lend/invest.

jafs 9 years, 2 months ago

What companies are currently creating jobs?

It seems to me that companies are laying people off and unemployment is increasing.

If we give tax cuts to corporations, there is no guarantee whatsoever that they will create more jobs, especially if there isn't a market for their products as Harry points out.

just_another_bozo_on_this_bus 9 years, 2 months ago

The Laffer Curve (often used as a justification for supply-side economics) describes the relationship between the tax rate, and the total amount of revenue that can be raised as a % of GDP. Obviously, if the tax rate is 0%, no revenue will be raised. And if the tax rate is 100%, then workers will have no disposable income, which is a defining characteristic of communist societies. So how content workers in this system are is 100% dependent on how well the government can meet their needs.

Where is the point between these two extremes at which government revenues are maximized while not creating a significant drag on the economy and income levels? Supply-siders would have us believe that it's at a maximum tax rate of 30% or (much) below, but I've read studies that say that point is actually somewhere around 65%, and maybe even as high as 80%.

In other words, those in the upper tax brackets don't find taxation to be a disincentive to do what they do to remain in that tax bracket until the tax rates exceed at least 65%.

gogoplata 9 years, 2 months ago

Ignore the Keynesians and start listening to the Austrian economists.

Chris Ogle 9 years, 2 months ago

Bozo- What happens when our national debt edges near 80% of our Gross Domestic Product?

All of us suffer!

Trobs 9 years, 2 months ago

You are incorrect. The housing crisis was caused by too much government regulation. They forced lenders into bad loans so that more people could buy a home. When the loans were not able to be paid back these backs started to hemorrhage money.

Again, it is to be believed that deregulation caused this. It didn't, the government forced lending on to these banks. That is the opposite of deregulation and the free market. It doesn't surprise me the banks are more then a little scared to give out any money now.

salad 9 years, 2 months ago

"The government is the single most inefficient method of transferring dollars from the taxpayer to any program. Why? Government costs of administration are notoriously high."

Not that govt. can't be inefficient, but Bush did his best to show that the private sector can be WAY more inefficient than govt. could ever even hope or dream to be. Healthcare is just one example, but Millitary contractors are the best. Talk about pouring money in a black hole and getting nothing to show for it. Govt. is actually the most effiecient at some things, where putting competition into the market would just create chaos and inefficiency (fire, police, airtraffic control, DMV, power delivery, highway system, etc..). Let's just all remember in the Republican zeal to sell out America to corporations, that corporations care about profit and nothing else: people don't matter. I'll take flawed govt. over corporate America any day.

just_another_bozo_on_this_bus 9 years, 2 months ago

"What happens when our national debt edges near 80% of our Gross Domestic Product?"

I sure wish Reagan and the Bushes had worried a little about that.

just_another_bozo_on_this_bus 9 years, 2 months ago

"You are incorrect. The housing crisis was caused by too much government regulation. They forced lenders into bad loans so that more people could buy a home."

Absolutely wrong. 85% of the subprime loans were made by private lenders who were not part of any government program. They did it voluntarily, and a very high percentage did it very irresponsibly.

Trobs 9 years, 2 months ago

Where did you get your 85% number?

The government gave out a CRA rating to banks. Four ratings - Outstanding, Satisfactory, Needs to improve and Substantial noncompliance. It's been reported by many former bankers that federal examiners who gave out the ratings pushed the Community Reinvestment Act. Basically stated, if you gave out bad loans, your rating would go up. Simply playing along with the system.

If you want to say the banks did it willingly, it was because this rating was forced on them. Get anything other then an Outstanding and you were not a good bank. So what do you do? Give out bad loans! Rating goes up, you make money, more people get into homes, the Community Reinvestment Act works!

Ignore the crash later down the line....

average 9 years, 2 months ago

Godot -

What got us out of the Depression (if you don't think we were getting out, slowly, by the late 30s)?


What was WWII, from a US economic perspective, but the largest government make-work project of all time? The Keynesian move to end all Keynesianism.

And, you might note, it continued for years afterwards. Kansas own Dwight D Eisenhower spent hundreds of billions on interstates, dams, schools, social projects, rebuilding Europe, etc. The top marginal tax rate during the Eisenhower administration? 91%. Right?

And, you know, a lot of people consider that era one of America's greatest. Are you suggesting the Truman, Eisenhower, and Kennedy years were totalitarianism?

jaywalker 9 years, 2 months ago

This has nothing to do with the article but a friend forwarded it to me. I found it fascinating, particularly when you look at the breakdown of presidential election voting by county.

Not trying to start a firestorm, just got me thinking in abstracts and thought some of you might appreciate it.

just_another_bozo_on_this_bus 9 years, 2 months ago

While a case can certainly be made that there wasn't enough oversight over lending institutions making bad loans while claiming to satisfy CRA, it's a considerable stretch to say that banks were "forced" to make bad loans to unqualified borrowers. They did so for many reasons, many of them quite nefarious and corrupt, and satisfying the CRA was nothing more than flimsy excuse to cover for their bad and often downright criminal behavior.

Trobs 9 years, 2 months ago

Former CFO of a bank and his story about the banking crisis. I'm sure because it's Ron Paul's site you will dismiss it out of hand.

The Government forced banks into these loans. This is not a revelation. No one cared because many people got into homes and that is exactly what the CRA was about. Only now that the banks have tanked does anyone care, and it is easier to blame the bankers than the failed policies placed on them.

salad 9 years, 2 months ago

Banks were not "forced" to do anything. You should watch the 60 minutes segment where they explain the mortgage crisis (it's complicated....really complicated), and the Seth Meyers bit from SNL where he condenses the 60 min. piece into about 10 sec. (funny). It comes down to this: When greedy people are making lots and lots of money they go "whoopee!!!" and don't really care about where it comes from or the consequences.

llama726 9 years, 2 months ago

Here's the issue:

We have a lot of people unemployed in the country

There are a lot of things that need to be done in this country that private business isn't taking care of, including: -Administering health care to the elderly / uninsured -Rebuilding roads, bridges, tunnels, fire stations, emergency response facilities, flood management systems, and other local government facilities / equipment -Digitizing tons of public records / documents -Rebuilding hospitals (have you guys seen some of the decrepit hospitals around the US?) -Rebuilding and enhancing the school system in our country so every kid actually gets a shot at a decent education -the list goes on

So why, why, why, WHY is the government so bad? I like having a fire department. I love having a post office. It's nice to have safe roads to drive on.

Trobs 9 years, 2 months ago

I have no problem with State and Local Governement. I have an issue with Federal Government. The stimulus is tossing money all over to pet projects, even with the "fat" cut off.

Imagine if you will. A small federal government. Their duty? Military protection for our country and diplomatic relations with the world. They do not regulate the country, they do not tax the country. The power is restored to the states. Kansas is allowed to do what is good for Kansas. No longer will our reps have to go to Washington and give concessions in order to get money passed back to the state. Instead, the state taxes as it sees fit. It runs the schools, the healthcare, the roads, etc all locally.

Let the power come back to where you live and the entire system changes. Great idea, doubt it will ever happen.

jonas_opines 9 years, 2 months ago

jaywalker: "As this map makes clear, large portions of the country are quite evenly divided, appearing in various shades of purple, although a number of strongly Democratic (blue) areas are visible too, mostly in the larger cities. There are also some strongly Republican areas, but most of them have relatively small populations and hence appear quite small on this map."

In other words, the Republicans, as Rugged Individualists can be classified following two guidelines. First, they can't stand other people. Second, they have enough success to fence themselves off in large tracks of land, so they don't have to be amongst the other people they can't stand.

Trobs 9 years, 2 months ago

Want to pay off the federal deficit? Just keep having Obama nominate people for his cabinet!

malehrman 9 years, 2 months ago

It is unfortunate that many pundits, now apparently including Prof. Shaffer, believe that a family is considered "relatively well off" if their house is paid off, they have nice savings and an annual income of $1.35 million dollars. It is unfortunate because people with these beliefs are the ones, on both sides of the aisle, making grand statements about the condition of the "average American worker" and have a significant impact on the economic decisions made by our government and financial institutions.

I don't think people in this mindset can make decisions that will be beneficial for the good of the entire country.

salad 9 years, 2 months ago

Trobs, we already tried your idea a long, long time ago and it was a disaster (articles of confederation). Washington and Adams quickly saw the need for a strong central govt. to keep the states united. If we put your idea into practice, then there would still be slavery in the south.

Trobs 9 years, 2 months ago

The Articles of Confederation were replaced not because we needed a stronger central government, but because of political pushing by the Federalists. The Federalists were against the idea of stronger states and the Constitution was ultimately a compromise between both sides. The idea was to give an even balance of power to the fed and the states.

Unfortunately since Lincoln the federal government has overstepped it's stated constitutional bounds and inflated itself more and more.

jonas_opines 9 years, 2 months ago

barrypenders (Anonymous) says…

"That funny, I see Darwinism used all the time to harrass the religious."

No you don't. You've probably seen religious people mistakenly think that people are using Darwinism to harrass them, because they have no understanding, or desire to understand, what anybody is actually talking about.

jonas_opines 9 years, 2 months ago

logicsound: You must have faith in the free market! We see through a glass darkly, the will of the market is all.

Have faith.

jaywalker 9 years, 2 months ago

jonas -

That is freakin' hilarious!! Not verbatim, but along the exact same lines my father uttered in reference to that site! I forwarded your comments to him and he said, "See!?" I've had the same sort of discussion with my uncle who lives in Buffalo on why so much of NY state is red but NYC is hard blue, and his (he's a poli sci prof) conclusions were also like yours. Not quite as harsh, but right there in the sweet spot.

salad 9 years, 2 months ago

"The Articles of Confederation were replaced not because we needed a stronger central government, but because of political pushing by the Federalists."

....and because they didn't work...and we needed a stronger central government. Clearly you have read only one tiny piece of the story. Under the articles of confederation, you had adjacent states placing punitive tarriffs on specific goods, militias threatening to go to war with other states over petty differences, large powerful states like Virginia throwing their weight around, etc, etc, etc,... it didn't work. So your argument about us not needing a strong central govt. is true in the same way that decapitation is a cure for dandruff.

Richard Heckler 9 years, 2 months ago

If tax cuts performed all of the magic that have been discussed over the past 30 years no one would be out of a job, everyone would own their own homes and all could afford new hybrid vehicles. So what broke down along the way?

RonBurgandy 8 years, 12 months ago

Excellent article. Well said and infomative. Too bad people still have their tax cuts do everything blinders on.

MyName 8 years, 12 months ago

logicsound04 your hypothesis smacks of anti-darwinism.

Capitalism is for Darwinists.

Capitalism isn't related to Biology at all. Moreover, capitalism is based on a set of man made rules and concepts (chief among those is private property). Natural selection is completely agnostic to those concepts: a society in anarchy where the looters and pillagers rule is equally bound by natural selection as one that favors those who can innovate to create and accumulate wealth. Though we can all agree about which society we'd rather live in.

Further more, if you look at the pure capitalistic system, people are forced to starve, not because of actual want or an inability to get food, but because man made rules dictate that they aren't allowed to have food because they didn't acquire enough small green pieces of paper. This is, to put it simply, not natural and is another example of how economics and biology aren't related.

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