Why Does Brad DeLong Worry About Paying For Tax Cuts?
Presumably Brad DeLong is happy that Congress did not push the economy over the cliff with the self-destruct austerity package it had designed to hold the country hostage. All that was simply to give Democrats the cover they needed to slash Social Security and other safety net programs.
But Brad worries about the long-run effects of evasion of the cliff-diving: since we did not eliminate all the Bush tax cuts, we still face a long-run funding problem. Here’s what he just posted at http://delong.typepad.com/sdj/2013/01/the-obama-tax-cuts-now-it-is-time-to-think-about-funding-them.html
“And now on to our big long-run problem: Unfunded tax cuts are, in the long run, bad juju. We cannot make policy on the expectation that the U.S. will always be able to borrow at negative real interest rates. And we should make policy aiming for a low debt-to-GDP ratio, because emergencies will arise in which we will want to boost federal spending quickly and substantially to attain important national purposes. Obama needs a policy to fund these tax cuts–not in the short-term or (probably) in the medium-term but in the long run. What is that policy going to be? Carbon tax? Include health and other benefits in the tax base? Cut defense spending? Lower the top bracket amount down to $100K? Inquiring minds would like to know…”
Well, my inquiring mind wants to know why Brad is worrying about “funding” tax cuts.
Let’s leave to the side the deficit and debt ratio bogeymen as those are the topics of the discussion GLF has begun with Ed Dolan. Here I only examine the notion that you must “pay for” tax cuts by either higher taxes or lower spending.
To be clear, a tax cut is the negative of a tax. Taxes reduce disposable income, so a tax cut means you do not take away income. I like to think of taxes as blood-letting. You put a catheter into the vein of a patient and drain the blood. A tax cut means you reduce the blood-letting. Asking how do you “pay for” reduced blood-letting is nonsensical. You simply reduce the flow of blood out of the patient.
OK, I admit this is not a perfect analogy but it does drive home a point. No analogy is perfect but let us try a better one. Economists often use a bathtub analogy to explain stocks and flows: water runs into the bathtub from the faucet (in-flow) that fills the tub (stock), so long as the water running out of the drain (out-flow) is less than the water running into the tub. If we plug the drain, the water stops running out—so the in-flow fills the tub.
Brad wonders how do we “fund” the reduced outflow?
I think that is a nonsensical question. Now, he might instead have wondered: what do we do when the tub is full? Would it then make sense to open the drain, or to slow the flow from the faucet? Sure. But how is that “funding” the previously reduced outflow during the period in which we closed the drain?
Makes no sense to me…..
Tax cuts today cannot be “paid for” later by tax increases or spending reductions. There could come a time in the future when we decide that aggregate demand is too high—perhaps sparking inflation. At that time we might raise taxes, or cut spending, or stimulate more production, or use non-price rationing, or institute wage and price controls, or… who knows? But if and when we take those actions, they do not “pay for” today’s tax cuts.
2 Responses to “Why Does Brad DeLong Worry About Paying For Tax Cuts?”
On the basis of his argument that there should be pre-funding of tax-cuts ( which amounts to saying that there cannot be an expansion of money in the economy without pre-funding ) there cannot accordingly be any creation of money by private bank lending without pre-funding. As most of us know from the current recession the blowing of a house price bubble ( the excessive creation of money ) by the private banks amounted to the imposition of a tax hike by draining demand out of the economy, a form of deflation. If the private banks had had to pre-fund their bubble it’s unlikely there would have been this “Demand Tax” drain. So Brad Delong is stuck. He cannot go on to reason that the creation of money for economic growth is fine from either government or private banks provided that it is carefully monitored and controlled to prevent either inflation or deflation.
Here is the sense in which tax cuts need to be paid for: tax cuts today increase the chance that aggregate demand will be too high at some point in the future and therefore that tax increases or spending cuts will be necessary at that time. To "pay for" tax cuts is to say that we recognize this issue and we are dealing with it in advance by putting into law those future tax increases or spending cuts that will possibly become necessary because of today's tax cuts.
How do tax cuts today increase the chance that aggregate demand will be too high at some point in the future? By giving people more wealth, which increases their likely future consumption. This is true no matter how the tax cuts are financed: you can increase the amount of government bonds that people hold, or you can increase the amount of Federal Reserve notes that people hold, or you can increase the face value of coins that people hold.
To the extent there is a wealth effect in the long run (and surely there is), people who hold more net assets (because of the tax cut) will eventually demand more resources and push the economy closer to a resource constraint than it would otherwise have been. Thus the need to restrict aggregate demand will come sooner, and future taxes will have to be higher than they would otherwise have been, or spending will have to be lower.