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.