Tag Archives: Ricardian Equivalence

Multipliers Are For Politicians

02 Wednesday May 2018

Posted by in Big Government, Fiscal policy, Stimulus

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Here’s a major macroeconomic sacred cow among professional economists and the politicians whose fiscal profligacy they enable: the presumed salutary effect of an increase in government spending on economic activity, including its so-called “multiplier effect”. Government fiscal stimulus is prescribed by the Keynesian school of economics to remedy any decline in the total demand for goods. A classic case is “underconsumption”, or excess saving, such that labor and capital resources are in excess supply. The idea is that government will mop-up some of this excess saving by borrowing and spending the proceeds on goods and services, putting resources back to work. In the standard telling, digging holes and refilling them is as effective as anything else. The increased income earned by those resources will be re-spent, creating income for the recipients and leading to repeated rounds of re-spending, each successively smaller due to “leakage” into saving. Adding up all these rounds of extra spending yields a multiple of the original government stimulus, hence the Keynesian multiplier effect. The stimulation of the demand for goods and services pushes the economy back in the direction of full employment, thus correcting the original problem of underconsumption. Nice story.

Keynesian economics is a short-run, demand-based framework that delineates behavior by the constructs of national income accounting, segmenting demand into consumer spending, investment in productive capital, government spending, and net foreign spending (net exports). Except for the limit imposed by full employment, the supply side of the economy and the processes giving rise to growth in productive capacity are ignored.

Within the Keynesian framework, can offer many qualifications to the story of a shortfall in demand to which even a dyed-in-the-wool Keynesian would agree. First, government stimulus cannot have an effect on the real economy at a time when the economy is operating at full capacity, or full employment. The increased government spending will only lead to bidding against other uses of the same resources, increasing the level of wages and prices.

Another qualification within the Keynesian framework is that the leakage from spending at each round of re-spending is made greater by taxes on marginal income, thus reducing the magnitude of the multiplier. In addition, some of the extra income will be spent on foreign goods — another leakage that reduces the multiplier effect on the domestic economy. In fact, this is why multipliers for spending at local levels are thought to be relatively small. The more local the analysis, the more income will be re-spent outside the locality at each round. More fundamentally, private parties should know that increased government borrowing must be repaid eventually. At some level, they know that additional taxes (or an inflation tax) will be necessary to do so. Therefore, their reaction to the additional income derived from government demand will be muted by the need to save for those future liabilities. Put differently, consumers do not view the gain as an increase in their permanent income. That’s essentially the mechanism underlying the “Ricardian equivalence” between methods of funding government spending (government debt or taxes).

In the “real world” there are many other practical problems that lead to ineffectual and even counter-productive government stimulus. One is the problem of cost control endemic to the public sector. Related to this are seemingly unavoidable timing issues. These factors have a strong tendency to make counter-cyclical fiscal programs too costly and too late. There is also the tendency toward graft and cronyism wherever the government spreads its largess. The “perfectibility of man” is certainly not evident in the execution of government stimulus programs. Their economic impacts often become pro-cyclical, or even worse, they become permanent increases in spending authority. More on the latter below.

Deeper objections to the Keynesian framework have to do with its demand-side orientation and the conceit that government, solely by borrowing and spending, can contribute to “real demand” and add to a nation’s output. And even if government spending takes up slack at a time of unemployed resources or excess supplies, it is unlikely to resolve the conditions that led to the decline in private demand. Therefore, even if government stimulus is successful in spurring a temporary increase in actual production and utilization of resources, it is likely to delay or prevent the downward wage and price adjustments necessary to permanently do so.

Recessions are typically characterized by an effort to work off over-investment in various sectors: housing, commercial structures, oil and gas extraction and processing, technology assets, inventories, or factories. Over-inflation of asset values is usually at the root of malinvestment, often accompanied by overinflation of wages and prices. These dislocations do not occur evenly, but the market process acts to correct misallocations and mispricing precisely where they occur. It might take time, but if government steps in to prop-up weak sectors, forgive the economic consequences of mistakes, and place more upward pressure on wages and prices, the dislocations will persist. So again, even if stimulus and the multiplier effect offer a short-term palliative, the benefits are illusory in a real sense. The long-run consequences of failing to allow markets to repair the damage will be negative.

One of the greatest skills that economists should possess is the ability to discern the most plausible counterfactual in a given situation: the world as it would have played out in the absence of a particular event, often a policy initiative. This is a great shortcoming among those who subscribe to the efficacy of government stimulus programs. In the scenario just described, there will be a decline in capital investment, consumption, and saving, but that saving, whatever its level, will still be channeled into capital investments unless the funds sit idle in bank vaults. If the saving is instead absorbed by the government’s effort to fund a stimulus program, even that reduced level of investment will not take place. The net effect is zero! Thus, the Keynesian stimulus and multiplier effect represent a failure of the economics profession to “see the unseen”, as Frederic Bastiat would have put it. Unless government can produce something of value to generate income, perhaps something that improves private returns, it will not contribute to income growth.

Permanent displacement of private capital investment is the most fundamental detriment of government fiscal activism. That it might well supplant private production should come as no surprise. Matthew D. Mitchell and Jakina R. Debnam describe the phenomenon this way:

“The tendency for ostensibly temporary spending to become permanent spending helps explain why policy makers fail to take the Keynesians’ advice when it comes to surpluses. Though governments invariable go into deficit during recessionary periods, they rarely run surpluses during expansionary periods.”

Mitchell and Debnam provide an interesting quote:

“… Richard Wagner and Nobel Laureate James Buchanan concluded: ‘Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian message, politicians can spend and spend without the apparent necessity to tax.'”

In a footnote, Mitchell and Debnam note that Milton Friedman once said, “Nothing is so permanent as a temporary government program.” The Keynesian prescription for stimulus allows politicians to assert that they are empowered to rescue the unemployed or those suffering a loss of income. They want you to believe that they can do something. The multiplier gives license to still greater mischief on the part of politicians, because it can help politicians sell almost any pork-barrel project. But continuing government expansion requires that it extract resources from the private economy. That’s true whether the government spends directly on goods or redistributes, and the mechanics of these processes involve additional resource costs. As long as government can borrow private savings, politicians will disguise the true cost of their munificence to constituents. Economists should not be their enablers.

Deficits Are a Symptom of Statist Excess

12 Monday Feb 2018

Posted by in Big Government, Taxes

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One thing’s clear with respect to President Trump’s budget proposal and the ongoing debate over appropriations: federal spending will increase and add to future budget deficits. This follows the Tax Cuts and Jobs Act (TCJA) enacted late last year, which many expect to add upwards of $1 trillion to deficits over the next 10 years. I have offered mixed praise of some of the reforms and rate cuts in the TCJA, though it does not accomplish much in the way of tax simplification and it will almost certainly require a large increase in federal borrowing. Ultimately, however, dollar for dollar, a tax cut giving rise to a deficit inflicts lower (or even negative) costs on the private sector than an unfunded spending binge, which is costly in the most basic terms: resources devoured by government.

Cost of Spending

The cost of an extra dollar of government spending at the most basic level is the value of lost opportunities to which the resources absorbed by government otherwise could have been put. When the government spends an extra dollar, and if the government pays a competitive market price, the goods and services exchanged for that dollar by private party “A” would be valued at more than one dollar by other private parties who lost the opportunity to trade with “A” for those same goods and services.

There might be a strong case for incremental spending in any particular instance, of course. Can we benefit from more national defense? Infrastructure? Grants of foreign aid? Subsidies for this industry or that? This technology or that? This cultural program or that? Public aid? Primary research? Regulatory budgets? I’d favor very few of those as general spending priorities. However, there are many subcategories and so many special interests that it is difficult to control spending as long as compromise is needed to accomplish anything.

The Trump budget is a mix of cuts in non-defense spending and large increases in defense, infrastructure outlays, and border security. On balance, it would lead to substantially higher budget deficits over the next ten years. He won’t get all of what he wants, but it would be astonishing if larger deficits are not an outcome.

Unfortunately, government is typically inefficient in the execution of its tasks and it is less responsive to price incentives than private buyers, who are fully vested in “ownership” of the dollars they spend. Government agents, no matter how honorable, simply do not have the same kind of stake in the outcome as a private owner. Obviously, spending by federal agencies is influenced by the political process, which creates opportunities for side rewards for those who direct or influence spending and those who receive the payments. These side rewards are pure private rents arising from public largess. For a private party, the profitability of transacting with government may well exceed the normal return to capital or entrepreneurship. The efficiency of government spending is compromised by its political nature and the uneconomic behavior of government agents. I therefore have strong doubts about the cost-benefit comparison of almost any public initiative.

Un-Taxing

The government ultimately acquires its funds from taxes enforced via coercive power. After all, tax collection requires a considerable enforcement effort. A tax payment of one dollar requires the sacrifice of things that would have been acquired, now or in the future, in voluntary, private transactions valued more highly than one dollar by the taxpayer. That is the nature of gains from voluntary trade foregone. The result is that one dollar of taxation extracts more than one dollar of value from the private sector. Conversely, a reduced tax liability of one dollar means that private parties can engage in an extra dollar of voluntary trade and benefit from the surplus.

There are few forms of taxes that don’t distort incentives in the private market. Taxes may blunt incentives for work, saving, and deployment of capital in productive uses. To the extent that these private decisions are twisted by taxes in ways that differ from fully voluntary decisions, there is a further loss of value and resource waste. Eliminating these distortions is always a worthy goal.

Funding Deficits

Government has ways other than immediate taxation of paying for excess spending. One is to borrow from the public, domestic or foreign. Those who purchase the government’s debt, loaning their money to the government, do so voluntarily. That debt carries an interest obligation by the government, and it must repay the principle some day. That will require new taxes and their attendant distortions, even more borrowing, and/or some other method of extracting value from the private sector. A principle known as Ricardian equivalence holds that the effects of government outlays are the same whether financed by taxes or borrowing, because taxpayers know that future taxes will be owed to pay off government debt, and so they discount that liability into their behavioral calculus.

Additional borrowing can create an unstable financial environment if borrowing occurs at interest rates higher than the economy’s rate of growth. Borrowing might also “crowd out” private borrowers, absorbing saving that would otherwise be used to finance investment in the economy’s productive capacity. In other words, the resources acquired with that extra dollar of government spending will lead to less private investment and a sacrifice of future production.

Sneaky Inflation Tax

Another way that government can pay for spending is by imposing an inflation tax. This amounts to a devaluation of privately-held assets accomplished by inducing unexpected inflation. It allows government debt to be extinguished in the future with dollars having reduced purchasing power. Essentially, more currency (or its electronic equivalent) is placed into circulation: money printing, if you like. That sets up the “too-much-money-chasing-too-few-goods” inflation cycle. But like any other tax, the inflation tax is involuntary and creates waste by inducing the public to respond to distorted incentives.

Summary

An additional dollar of government spending absorbs a dollar of resources, and destroys more value than that given lost surplus to those who would otherwise have benefited from those resources. Moreover, the spending often fails to return a full dollar in benefits, often lining the pockets of elite grifters in the process. Ultimately, the funding for incremental spending must be commandeered from private parties via taxes or an inflationary taking of assets. Public borrowing might conceal the reality of taxes for a time, but it may crowd out productive investment that would otherwise enhance economic growth. So a case against incrementally larger government can be made in terms of resource costs as well as the distortionary effects of taxes and dissipation of future private growth.

By the same token, an ostensible reduction in taxes might be illusory, to the extent that future taxes or an inflationary taking will be necessary to cover the debt one day. On the other hand, there is no direct resource cost involved, and a tax reduction unbinds constraints and distortions on private incentives, which is unambiguously beneficial. And that’s true as long as the tax reductions aren’t targeted to benefit particular sectors, parties or technologies in any new misadventures in government central planning.

Deficits, in and of themselves, are either irrelevant or possibly damaging to long-term economic growth. You’ll get them with either tax cuts or spending hikes. But spending hikes absorb real resources, whereas tax cuts release resources by transforming a dead weight loss in private markets into proper gains from trade. If deficits are a problem, and if eliminating them requires costly tax distortions, then the real problem is the expanse of the state.

Tax Cuts Yes, Simplification a Mixed Bag

18 Monday Dec 2017

Posted by in Taxes, Trump Administration

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President Trump signed the Tax Cuts and Jobs Act (TCJA) this morning, the GOP tax bill with an acronym that simply won’t roll off my tongue. A useful summary of the Act produced by the House -Senate conference, and the full text of the Act, appear at this link. The TCJA hews more toward the earlier Senate bill than the House version. I’ve written about both (the House bill here and both here). Here is a good summary of the Act from Peter Suderman at Reason.com.

In my earlier assessments, I relied upon the principle of tax reform and real simplification as a justification for a tax cut without revenue neutrality. There are a few reforms and partial reforms, and the bill may simplify taxes for a number of individual taxpayers. However, on the whole I’m disappointed with the progress made by the GOP in those areas.

Notwithstanding my disappointment with the overall reform effort, the TCJA cuts taxes for most Americans and is likely to have salutary effects on economic growth and the job market. In fact, one of the most remarkable things about  the Act is the claim made by its adversaries on the Democrat side of the aisle. They apparently believe that the benefits of the TCJA flow primarily or even exclusively to the rich. This is a huge mistake for them. High-income taxpayers will receive greater benefits in absolute dollars, but not proportionally. This is shown by the table above, prepared by Chris Edwards from data produced by the Joint Committee on Taxation (JCT). In fact, the TCJA will extend tax reductions to a larger share of the middle class than either of its predecessor bills would have done. You cannot meaningfully reduce the taxes generated by a steeply progressive tax system without reducing the absolute dollars paid by high-income taxpayers. And you can’t lay the groundwork for sustainable economic growth without improving the investment incentives faced by high-income taxpayers and producers.

Here are some additional additional thoughts on the bill:

Yeah, I like me some tax cuts: The Act reduces taxes for many individuals and families by doubling the standard deduction and reducing tax rates. More importantly, perhaps, it will also reduce taxes for C-corporations, providing some relief from double taxation of corporate income, as will the switch to a territorial tax system on U.S. corporations doing business abroad. The latter is a real reform, while I consider the former a partial reform. Investment incentives are improved via the corporate rate cut and elimination of the corporate Alternative Minimum Tax (AMT) — a real reform, as well as the ability to write-off spending on new equipment immediately. As I argued last month, lower corporate taxes are likely to benefit both workers and consumers. The actions of few companies (AT&T, Comcast, Wells Fargo, and Fifth-Third) seem to demonstrate that this is the case: they have announced bonuses and increases in their base wage rates in the immediate wake of the TCJA’s massage.

Pass-through tax cuts are iffy: One of the most difficult parts of the TCJA to evaluate involves the implications for pass-through business entities like sole proprietorships, partnerships and S-corporations. Some might not receive significant cuts. The Act includes a maximum 25% rate on business income, but that is dependent on the proportion of the owner’s income deemed to be business income under the new rules. It also allows a flat deduction of 20% against business income. These provisions will be of benefit to very successful and very capital-intensive pass-throughs. Owners of smaller or less profitable firms will get the benefit of lower individual tax rates and the higher standard deduction, but might not have income high enough to benefit from the 25% rate cap.

Simpler for some, but it is not simplification: The doubled standard deduction will mean fewer taxpayers claiming itemized deductions. That sounds like simplification, but many will find it reassuring to calculate their taxes both ways, so a compliance burden remains. The Act retains or partially retains a number of deductions and credits slated for elimination in earlier versions, failing a simple principle held by reformers: eliminate deductions in exchange for lower rates. Along the same lines, the individual AMT is retained, but the exemption amount is increased, so fewer taxpayers will pay the AMT. Again, simpler for some, but not real simplification.

Elimination of the corporate AMT is simplification, as are immediate expensing of equipment purchases and territorial tax treatment. However, most of the complexities of corporate taxes remain, as do certain tax breaks targeted at specific industries. What a shame. And unfortunately, taxes for pass-through entities are anything but simplified under the Act. Complex new rules would govern the division of income into business income and the owners’ wage income.

Reducing deductions and bad incentives: The mortgage interest deduction encourages over-investment in housing and subsidizes the wealthiest homebuyers. The TCJA leaves it intact for existing mortgages, but allows the deduction to be claimed on new mortgage loans of up to $750,000. So the bad incentive largely remains, though the very worst of it will be eliminated. There have been complaints that this change could reduce home prices in states with the highest real estate prices. Good — they have been inflated by the subsidy at the expense of other taxpayers.

The tax write-off for state and local taxes (SALT) will be limited to $10,000 a year under the TCJA, though it adds some flexibility by allowing that sum to be met by any combination of state or local income, sales or property taxes. This change will reduce the subsidies from federal taxpayers residents of high-tax states, and should make leaders in those states more circumspect about the size of government.

The TCJA preserves and even expands a number of individual deductions and credits, subsidizing families with children, medical expenses, student loans, graduate students, educational saving, retirement saving, and the working poor. The interests benefiting from these breaks will be relieved, but this is not simplification.

Yet another case of “simpler for some” is the estate tax: it remains, but the exemption amounts are doubled. The estate tax does not produce much revenue, but it is fundamentally unjust: it ensnares the families of deceased property owners, farmers and small businesses; planning for it is costly; and it often forces survivors to sell assets quickly, sustaining losses, in order to meet a tax liability. The TCJA will significantly reduce this burden, but the tax framework will remain in place and will be an ongoing temptation to ravenous sponsors of future tax legislation.

Individual cuts are temporary: The corporate tax changes in the TCJA are permanent. They won’t have to be revisited (though they might be), and permanence is a desirable feature for sustaining the impact of positive incentives. The individual cuts and reforms, however, all expire within eight to ten years. The sun-setting of these provisions is, as some have said, a gimmick to reduce the revenue impact of the Act, but sunsetting means another politically fractious battle down the road. It is also a device to ensure compliance with the Byrd Act, which limits the deficit effects of legislation under Senate reconciliation rules. Eight years is a fairly long “temporary” tax cut, as those things go; for now, the impermanence of the cuts might not weaken the influence on spending. However, that influence is likely to wane as the cuts approach expiration.

Deficit Effects: The TCJA’s impact on the deficit and federal borrowing is likely to be somewhere north of $500 billion, possibly as much as $1.4 trillion. Deficits must be funded by government debt, which competes with private debt for the available pool of savings and must be serviced, repaid via future taxes or inflated away. In the latter sense, government borrowing is not really different from current taxes, a proposition known as Ricardian equivalence.

Nonetheless, the incentives, complexities and compliance costs of our current tax code are damaging, and the TCJA at least accomplishes some measure of reform. Moreover, the incremental debt is small relative to the impact of prior estimates of government borrowing over the next decade, with or without extension of the individual tax cuts. The most fundamental problem that remains is excessive government spending and its competing demands for, and absorption of, resources, with no market guidance as to the value of those uses.

Weighing Tax Reform vs. Spending and Deficits

05 Tuesday Dec 2017

Posted by in Taxes

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The tax reform legislation likely to come out of the House and Senate reconciliation process will be far from ideal, but it will be much better than current tax law in several respects (see my last several posts listed in the left-hand margin). One complaint raised by Democrats and others, however, is that the GOP tax compromise will lead to higher budget deficits. Of course they are right, but Democrats fail as legitimate critics given their hypocrisy on the issue of deficit spending. And chronic deficits are ultimately a symptom of government excess. Deficits exist when the polity is unwilling to support the explicit taxes necessary to pay for the spending that politicians are willing and able to authorize.

Nevertheless, there is near-universal consensus that the tax plans passed by the House and Senate would add to the deficit if either were to become law, the biggest exception to that consensus being Republican leadership. The Joint Committee on Taxation (JCT) has estimated that the Senate plan would add $1.4 trillion to the deficit without the benefit of economic feedback. That shrinks to about $1 trillion with the dynamic feedback effect of resultant economic growth. Others believe the gap would be smaller, however. The Tax Foundation, for example, estimates the net cost in tax revenue at $500 billion. Veronique de Rugy quotes a dynamic score by Quantria/Inforum that would put the revenue loss at about $300 billion, based on the starting JCT static estimate. The Tax Foundation, as noted by de Rugy, believes the JCT errs in treating the U.S. economy as a closed economy in which business funding is limited to a fixed pool of domestic saving, and in assuming that the Federal Reserve would attempt to offset the economic growth spurred by the tax cuts. These JCT assumptions mute the economic and revenue responses to tax changes.

But whether you believe the JCT’s estimates or the others, the impact is relatively minor compared to the existing fiscal shortfalls brought on by government excess. Brian Riedl puts the proposed tax cuts in perspective. The 10-year deficit was already projected at $10 trillion, with little apparent concern from Democrats. Riedl notes that the opposition has repeatedly shown itself unwilling to address fiscal problems such as Obama’s deficit legislation, Bernie Sander’s $30 trillion health care plan, and a shortfall in Social Security and Medicare funding of $82 trillion over the next three decades:

“Critics who are unwilling to confront these mammoth spending deficits are in no position to lecture others on the deficit implications of a (comparatively modest) $2 trillion tax cut.“

Jeffrey Tucker, whose posts I usually enjoy, seems to assert that deficits are not worthy of great concern. He offers a negative and somewhat muddled assessment of Ricardian equivalence, the idea that deficit spending is neutral because the expectation of future taxes discourages private spending. Tucker’s position is rooted in impatience with the rhetoric of revenue neutrality, but I think his real point might not be too far from Reidl’s. To his credit, Tucker condemns “fiscal profligacy”. He says:

“To be sure, this is not a defense of fiscal irresponsibility. Debts and deficits are terrible. Fiscal conservatism is a good thing. The budget should always be balanced. But there is one proviso: none of this should happen at the expense of the wealth creators in society: you, me, and the business sector. Government should bear responsibility for its own profligacy.“

I will interpret that last remark generously to mean that Tucker would cut spending to shrink deficits, but he also advocates for the sale of federal assets, which I generally support.

Concern by some Republicans over the deficit effects of tax reform prompted a debate during the Senate negotiations over a so-called “trigger” that would have increased taxes automatically if revenue fell short of certain benchmarks. At the last link, Ryan Bourne explains what a bad idea that would have been. A future revenue shortfall could be attributed to any number of future developments, not all of which would be compatible with a tax hike as a fix. The trigger would also create uncertainty, dampening the positive revenue effects that would otherwise be operative. It’s a relief that the trigger idea was abandoned by the GOP.

Despite the corrosive effects of big government and excessive spending, there is a relatively painless solution to closing the fiscal gap, with or without GOP tax reform. (I use the word “painless” guardedly, because big government inflicts distortions and costs well beyond mere spending levels.) Dan Mitchell has updated his calculations showing that the annual deficit would be eliminated by a decline in the budgeted annual growth of spending from 5.49% to 2.67% over ten years, starting in 2019. That hardly seems draconian, but watch: progressives and even relatively reflective Democrats would call such growth reductions “heartless cuts”. Such is the intellectual integrity of the left.