Cutting Taxes Hurts The Economy

“At pos­i­tive inter­est rates, a labor tax cut is expansionary,as the lit­er­a­ture has empha­sized in the past. But at zero inter­est rates, it flips signs and tax cuts become con­trac­tionary. Mean­while, the mul­ti­plier of gov­ern­ment spend­ing not only stays pos­i­tive at zero inter­est rates, but becomes almost eight times larger.” (Source, via)

Cut­ting taxes, in other words, makes a reces­sion worse. Why? The answer hinges on a model in which, at zero inter­est rates, aggre­gate demand is extremely expectations-​​based. (Quick supply-​​demand review video here.) What this in turn implies is that, unlike in a nor­mal sit­u­a­tion, a higher price level implies a higher level of demand for goods: that is, the demand curve is upward-​​sloping as expec­ta­tions for infla­tion increase. In this sit­u­a­tion, we can see that tax cuts hurt the economy:

And that addi­tional gov­ern­ment spend­ing is extremely beneficial:

…even from a New Key­ne­sian the­o­ret­i­cal basis. This may answer that ques­tion floated the other day about why Con­gress refuses to pur­sue a tax-​​cut-​​based stim­u­lus pro­gram even when there is no polit­i­cal appetite for an addi­tional spending-​​driven one: there would be no eco­nomic ben­e­fit to those cuts.

Hence we get sto­ries like today’s Hot Air, which notes that Cash For Clunk­ers accom­plished lit­er­ally noth­ing. Unfor­tu­nately Ed makes one big mis­take in his analy­sis of the prob­lem: call­ing it Key­ne­sian. It isn’t. It’s a classical-​​conservative tax-​​break/​direct-​​subsidy (remem­ber, the two are equiv­a­lent) pro­gram. A true Key­ne­sian pol­icy would involve direct gov­ern­ment invest­ment, much as the ear­lier stim­u­lus pack­age, which by now has cre­ated over 3 mil­lion jobs and cut unem­ploy­ment by 1.5 per­cent. Now that’s Key­ne­sian, and that’s successful.

(Photo: alancleaver_​2000)

4 June 2010 – 2:59 pm | By Benjamin Daniels | Posted in Economics | Comments (196)