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Economic Myths In Economic Textbooks

If you were to examine virtually any of the textbooks currently used to teach economics in college classrooms, you will find "Tax Cuts" listed under the heading of "Tools of Expansionary Fiscal Policy."

It is an unfortunate error of great significance, for it is at least partly responsible for the failed experiments with Austerity that we have witnessed in recent years on both sides of the Atlantic (at great human cost).

It is an error that seems almost inexplicable coming from professionals who are accustomed to thinking of themselves as 'scientists' devoted to the ideals of accuracy and precision.

To an economist, the macroeconomy is a vast 'problem' containing dozens of economic 'variables' that they would like to be able to make some sense of.

One of their most basic scientific instincts has been to state with precision what kind of impact on the economy's overall performance we should be able to expect when certain of those economic variables is changed (increased/decreased).

This is not always the easiest thing in the world to do, for there are usually more than a few economic variables involved, and that can make it very difficult to say which variable is responsible for what percentage of the changes we are seeing in the overall economy.

To make this challenge less daunting, social scientists make full use of the cereris paribus assumption, wherein they assume for analytical purposes that all other economic variables are held constant.

If we assume that no other economic variables are allowed to change, we are then able to isolate the impact that a single changed variable is responsible for with respect to the overall economy.

It is an analytical approach that is invoked quite frequently in the typical introductory Economics textbook, but for some reason, it is utterly ignored when lists are compiled of those fiscal policy initiatives which are said to be expansionary vs. those which are said to be contractionary.  

I find it incredible that mainstream economists have never bothered themselves to identify---for the record---what the isolated effect is that a tax cut has on the economy, when all other economic variables are held constant.

In other words, if you cut taxes, but do nothing else (e.g., do not borrow money to maintain government spending), what will the ‘pure effect’ of a tax cut be on GDP? Answer: it will decline.

Tax cuts are contractionary because governments cannot spend money that they do not have. If taxes are cut and nothing else is done to sustain government spending, then government spending is going to drop by the amount of the drop in tax revenue.

Because not all of the tax ‘refund’ will be spent (some of the money will be removed from the economy by savers), the increase in consumption C generated by the tax cut is going to be less than the drop in government spending G that will also be caused by the tax cut.

That, my friends, is what we call a contractionary effect, a caused drop in GDP that is initiated solely by a reduction in taxes collected.

Raising taxes, on the other hand, is expansionary if at least some of the tax revenues collected by the government would have been saved. The increase in G is greater than the drop in C.

Money that would otherwise have been removed from the economy by savers is spent, instead, by the government.  The result is a net increase in aggregate demand, in GDP, and that is the very definition of the term ‘fiscal stimulus.’

This consequence of raising taxes is precisely the opposite of what Republican politicians have been telling us for decades.  ("Oh, the last thing you want to do during a recession is increase taxes!!")

It is true that if the government cuts taxes while maintaining its spending levels with borrowed funds, a net stimulus to the economy is generated, but none of the increase in GDP effected by this fiscal policy ‘combo initiative’ can be rationally attributed to the tax cut.

All of the stimulus effect we would observe would be derived from the spending of borrowed money, money that had been removed from the economy by savers.

Tax cuts BY THEMSELVES are always contractionary (or at least, never expansionary). But when the government borrows money to finance a tax cut, the stimulative effect of spending borrowed money is usually enough to overcome the contractionary effect of the tax cut (sometimes only barely: see The Bush Years).

If a government (e.g., Greece) wants to reduce the amount of money it borrows at the same time that it is giving a stimulus to the economy, it has no choice but to increase government spending and finance that additional spending on infrastructure through tax hikes on rich people.

Imagine, for example, if equal amounts of additional revenues generated by a tax hike were spent by the government on (1) entitlement spending and on (2) new spending on infrastructure.

The new tax revenues spent on 'old spending commitments' would reduce the government's total borrowing needs by an equal amount.

The new tax revenues spent on new infrastructure would provide a true economic investment to the nation at the same time that government debt is being reduced.

Again, the consumption C of rich people would drop, but it would be more than made up for by the increase in government spending G that would also occur.

The empirical evidence available supports the claim that tax cuts are contractionary and tax hikes are stimulative, especially when the tax cuts/hikes affect primarily rich people.

Paul Krugman put together a nice graph that illustrates this cause and effect relationship quite clearly.
The impact of tax cuts/hikes on the economy
It is certainly not unexpected that Republican economists/politicians would use specious arguments to justify their self-serving policy proposals.

But what excuse do ‘left-leaning’ economists have for meekly accepting the clever political efforts of right-wing economists to depict their contractionary agenda (tax cuts) as stimulative by combining it with an initiative that actually is stimulative?

(…and then they turn around and condemn the one thing that makes a tax cut economically justifiable and politically palatable: the borrowing...)

I can only hope that one day lefty economists will match the political saavy of Republican economists and take away their specious “tax cuts stimulate the economy” claim once and for all.

Crossposted at Nontrivial Pursuits

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Comment Preferences

  •  Refreshing (3+ / 0-)

    Thank you!  This makes a lot of sense, and I think I will be taking another look at my lesson plans in AP Econ.

  •  So from your (Krugman's) chart, why (1+ / 0-)
    Recommended by:
    The Angry Architect

    does the economy grow after the second Bush tax cut?  I realize there are plenty of things going on, but your argument is damaged by the chart you purport shows your thesis.

    •  The economy finally began to grow... (6+ / 0-)

      ...(1) after some of the contractionary effect of the tax cut began to wear off and (2) the bubble economy began to take off, such as it was.

      The bubble economy was also created by the Bush tax cuts, which essentially put billions more $$ into the loanable reserves of bankers, who started lending like crazy, even to high-risk borrowers (they were able to cover the risk in part by packaging bad loans with good ones and sell them to rich people/institutions that had a lot of money to spend/invest.)

      Besides, they were able to 'buy insurance' against their bad bets with AIG, which also encouraged them to lend with abandon.

      So the spending of borrowed money was sufficient to overcome the contractionary effect of the tax cuts; it just wasn't the government's borrowing that provided most of the economic stimulus (Although Bush did increase the federal government's borrowing to maintain federal spending levels).

    •  Due to borrowing (2+ / 0-)
      Recommended by:
      James Kroeger, semiot

      Basically the Iraq War started in 2003, and they borrowed to finance it:

      http://research.stlouisfed.org/...

      Later on, you also had growth due to the housing bubble.  Rising asset prices can cause people to spend more, but that tends not to be sustainable over time (eventually the bubble bursts).

  •  Not what all things equal means. (1+ / 0-)
    Recommended by:
    James Kroeger

    I think you are making a very valuable point by focusing on the distribution of tax cuts. Indeed it is kind of silly to talk about a debt- deflation recession without talking about the distribution of wealth but economists have tried valiantly to do that for so long they seem to have forgotten there is any problem.

    Nonetheless, the ceteris parabus for tax cuts is not less spending. It is holding spending constant and financing out of debt issuance (including just printing money).

    If the analysis is at the level of economic aggregates, increasing taxes is contractionary. If we disaggregate taxation to consider asymmetric effects we may see counter effects through the backdoor of interest rates. The mechanism claimed for "Clintonomics" was that deficit reduction lowered interest rates which positively impacted net debtors, effectively creating a fiscal stimulus through income distribution that more than offset any direct contractionary impact.

    •  Hmm... (1+ / 0-)
      Recommended by:
      wsexson
      ...the ceteris parabus for tax cuts is not less spending. It is holding spending constant and financing out of debt issuance (including just printing money).
      Yes, I realize that the ceteris paribus assumption has been misapplied so as to hold spending constant, in spite of the fact that there is no cogent reason for doing so.

      I understand what they do and I'm saying that it is stupid and foolish and it misrepresents the real effects of tax cuts---especially those that are bestowed largely on the Top 10% of Income earners.

      The mechanism claimed for "Clintonomics" was that deficit reduction lowered interest rates which positively impacted net debtors...
      Yes, that's what they claimed and it was as ridiculous then as it is now.

      The Fed has complete control over the supply of money, which means that it always has control over the price of money, the interest rate.  Surely you know this.

      If the analysis is at the level of economic aggregates, increasing taxes is contractionary.
      Yes, I know what is claimed, but you didn't give the explanation as to why it is supposed to be true, juxtaposed with my explanation.  That was what I was looking forward to but you never got there.

      How can the raising of taxes be conceptualized as contractionary when the increase in G is greater than the decrease in C?  (Don't give me the accounting identity S = I; it's worthless)

      •  No, they don't (0+ / 0-)

        As long as the Fed is committed to setting the interest rate, they have no control over money creation.  In essence, the Fed sets the price of new money and the markets for reserves determines the volume.

        Constitutionally, Congress has absolute control over the currency, control which they have delegated to a semi-private central bank.  From a consolidated government-sector point of view, the government has no financial need to levy taxes to pay for spending; it can print the money it needs.  

        Our government has a stupid rule.  We don't allow the Government's bank account at the central bank to be over-drawn, and we don't allow the Government to borrow money from (i.e. sell bonds to) the central bank directly.  They first have to borrow money from private lenders, who then go on to sell that debt at a profit to the central bank, who engage in open market operations (buying and selling bonds and reserves), in order to control the prime rate of interest.  

        Here's the dirty little secret: when the central bank is in a net-buying position, which it always is, that is, when they've bought up more bonds than they've sold, the difference is money they've printed into existence.  Our government really does just print money to fund it's spending, it's just set up a convoluted system that lets private banks play middlemen and get a cut of that printed money before it's spent.

        In fact, broadening the view to encompass the entire economy, the government always spends first, then taxes.  It has to spend first because that's how money is created, by the government printing it and then handing it out in exchange for stuff.  A government can't tax if it hasn't first spent because there won't be any money to tax.

        Taxes exist for three purposes: to erode excessive and imbalanced accumulations of savings, to drain demand in order to "make room" for government spending, so that spending won't be inflationary, and to drive the demand for the currency that's taxed.

        There is something to be said for your analysis, however, insofar as it buys in to the myth that a sovereign government has to finance its spending through taxing or borrowing.  Even if you buy into that premise, however, there are some flaws.  First, you have to be sure that the flow of money you're taxing won't be spent on consumption.  If the greater proportion of that flow is going to be saved, then sure, taxing and spending it is stimulative.  But if that flow of money is wages, well, wages are spent, virtually 100% of them.  Increase taxes on wages, which means your traditional income tax, and your increase might not be depressive if the money is then spent properly, but it won't be very stimulative, and it won't feel very good to the people  who's taxes got raised, because while they might have saved some (small) proportion of it, they would have spent the bulk, and now they can't.

        Second, the idea of ceteris paribus doesn't mean that you get to hold everything constant except one variable and then see what happens.  If you do that, then what happens is one variable changes...and that's it.  With economics, you have to make choices about which variables to hold constant.  You can choose to hold spending constant while raising or lowing taxes, and that has effects on how much money is borrowed, or you can choose to hold borrowing constant while raising or lowering taxes, and that has effects on how much money is spent.  In reality, we set our spending and we fiddle with taxes, meaning the amount we borrow is dictated to us.  This reality is closer to the model you critique than the model you offer.

        From such crooked wood as that which man is made of, nothing straight can be fashioned. -Immanuel Kant

        by Nellebracht on Mon May 14, 2012 at 11:18:57 PM PDT

        [ Parent ]

  •  Economics is a theology, not a science. The law of (1+ / 0-)
    Recommended by:
    J Orygun

    supply and demand is pretty much true, but the rest is mostly nonsense.

    •  Lol... (1+ / 0-)
      Recommended by:
      bunsk

      Actually, the 'law' of supply and demand is only a generalization...there are exceptions that run counter to the rule.

      There's something to be said for adopting a 'scientific attitude' even if you are not able to control all of the variables that 'hard' scientists are able to control.  (Oh yeah, and then there's cosmology... :)

    •  nonsense (1+ / 0-)
      Recommended by:
      James Kroeger

      That's what all the advocates of austerity say when we try to explain Keynes' admonition that the government should spend more during economic downturns.  Them economists are just nonsense.  Better to cut the budget in a recession.

    •  Nope. (1+ / 0-)
      Recommended by:
      Sky Net

      There are basic identities in macro economics. And some basic results work (in both micro and macro).

      But there are also plenty of hard questions that don't have unambiguous answers. And our ability to experiment is limited, and our actual data very noisy.

  •  goldilocks rate (1+ / 0-)
    Recommended by:
    Sky Net

    Somewhere is a sweet spot for tax rates.  Maybe Clinton found it.  If taxes are too high, there is little point in expanding.  If taxes are too low, necessary investments in infrastructure, education, and all our other important needs can't be met.  somewhere is the Goldilocks rate...not too high and not too low.

    Greece is different.  Combine excessive public expenditures with failure to collect...double fail.

  •  Tipped and recommended, as usual. Good to see (1+ / 0-)
    Recommended by:
    James Kroeger

    you back here again, James.

    "Those who are too smart to engage in politics are punished by being governed by those who are dumber." Aristotle

    by camlbacker on Mon May 14, 2012 at 07:51:19 PM PDT

  •  The Bush years (1+ / 0-)
    Recommended by:
    James Kroeger

    I've always been convinced that the reasonably healthy economy during most of the GWB years had nothing to do with tax cuts and everything to do with running deficits.  Deficits create money that goes into the economy.  That's why Republicans like them so much.  Whee!

    Here's an idea: how about the people run the government and the corporations can line up for whatever we leave for them.

    by J Orygun on Mon May 14, 2012 at 10:08:55 PM PDT

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