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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

Originally posted to James Kroeger on Thu May 17, 2012 at 05:40 AM PDT.

Also republished by Keynesian Kossacks.

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Comment Preferences

  •  Tax cuts on whom? (4+ / 0-)

    Your arguments appear fashioned for the case of tax cuts for the wealthy or for big corporations, the kind favored by Republicans and their fellow-traveler Blue Dogs.  Tax cuts on middle- and lower-income Americans have an expansionary effect, because they have more money to spend and will spend it rather than saving it.  They have a similar effect to food stamps, unemployment payments and other money delivered to people who will spend it all, increasing economic activity with a good multiplier effect.

    Government can spend money it doesn't have, and does so all the time.  But there is a cost in terms of capital removed from other uses, and eventual inflationary pressures due to high government debt.  Agree with you that raising taxes on the wealthy is economically stimulative, because it decreases government borrowing and avoids these costs.  And money sequestered in the hands of the wealthy is not being used to generate more economic activity unless it is productively invested -- which is no longer fashionable on Wall Street, at least.

    When Free Speech is outlawed, only outlaws will have Free Speech.

    by Dallasdoc on Thu May 17, 2012 at 05:56:46 AM PDT

    •  Exactly right. n/t (1+ / 0-)
      Recommended by:
      Calamity Jean

      Occupy is the symptom. Fundamental reform is the cure.

      by Tim DeLaney on Thu May 17, 2012 at 06:28:08 AM PDT

      [ Parent ]

    •  Well... (3+ / 0-)
      Tax cuts on middle- and lower-income Americans have an expansionary effect, because they have more money to spend and will spend it rather than saving it.
      Actually this is not true, not if government spending was cut by an amount equal to the drop in tax revenues, as I took pains to point out.

      You see, even if all of a tax cut was spent, it would only match the amount of government spending cut, which means that GDP would neither grow or decline.  It is true that a tax cut directed at the lower income earners would be less contractionary than a tax cut for rich people, but there is still no net increase in GDP.

      Government can spend money it doesn't have, and does so all the time.
      I don't know why you're ignoring the fact that the act of borrowing money is a completely separate fiscal initiative that has no necessary connection to a decision to cut or increase tax collections.  

      When the government 'spends money it doesn't have' as you state, it does, in fact, have the money because it has borrowed it from somebody or some bank.  Is there some reason why the rhetoric you're defending appeals to you?  It doesn't help the Progressive Cause a smidgen.

      •  What if gov't "spends" the money to pay down debt? (1+ / 0-)
        Recommended by:
        James Kroeger

        Would this not be the same as the rich sequestering the money?

        Interestingly, despite all the gov't borrowing, interest rates have still not ballooned.

        West. No further west. All sea. -- Robert Grenier

        by Nicolas Fouquet on Thu May 17, 2012 at 06:38:16 AM PDT

        [ Parent ]

        •  If... (1+ / 0-)
          Recommended by:
          Nicolas Fouquet

          ...the economy has recovered to the point where unemployment is zero, then excess tax revenues could be used to buy back the bonds it sold, that that by itself does little/nothing to stimulate the economy.  (No stimulus would be needed if unemployment is 0%).

          Interestingly, despite all the gov't borrowing, interest rates have still not ballooned.
          Your puzzlement is due to another error that is taught right out of the textbooks, and that is the notion that interest rates are set by "The Market."

          In truth, the Central Bank---The Fed---has 100% control over the money supply, which means that it can always set the interest rate at whatever level it wants, by simply manipulating the supply of money so as to maintain the relationship needed to produce a certain interest rate.

          It does this all the time, but still the myth is promoted by most economists that the central bank can be forced by fickle market players to do things it doesn't want to do.

          •  Control of interest rates, but not inflation. (1+ / 0-)
            Recommended by:
            James Kroeger

            But that hasn't really ballooned, either.

            Regardless, I understand the argument you are making which is that apart from buying back bonds, no tax cuts can be as stimulative as money in the government's hands because at almost all times, it spends it all.

            Republicans will argue that wasteful spending on entitlements would be better put in the hands of the rich and successful.  It seems there is data that suggests otherwise presuming entitlements are spent on living expenses.  

            Interesting that Republicans are quick to warn of impending doom from debt, but are happy to ignore melting sea ice (both long term concerns).

            West. No further west. All sea. -- Robert Grenier

            by Nicolas Fouquet on Thu May 17, 2012 at 07:14:58 AM PDT

            [ Parent ]

      •  I don't agree with this: (2+ / 0-)
        Recommended by:
        Dallasdoc, James Kroeger
        Tax cuts on middle- and lower-income Americans have an expansionary effect, because they have more money to spend and will spend it rather than saving it.
        Actually this is not true, not if government spending was cut by an amount equal to the drop in tax revenues, as I took pains to point out.
        The hidden assumption in this argument is that government spending is entirely equivalent in its effect to the spending of lower income strata. This simply isn't true. 100 million people buying flat screen TV's and new automobiles has a different effect in the economy than, say, military spending.

        Occupy is the symptom. Fundamental reform is the cure.

        by Tim DeLaney on Thu May 17, 2012 at 06:41:12 AM PDT

        [ Parent ]

        •  There are differences, of course... (2+ / 0-)
          Recommended by:
          Tim DeLaney, Roger Fox

          ...but they are not as substantial as you apparently think, when it comes to the problem of unemployment.  

          The private sector might spend the money on TV's or they might spend it on prostitutes and porn and drugs or mindless entertainment.  

          All in all (with military spending the great exception), I'd argue that government spending is usually more worthwhile than the alternatives that the private sector might otherwise choose to spend the money on, if it had it.

          •  I would agree, but consider ... (1+ / 0-)
            Recommended by:
            James Kroeger

            that military is a huge part of the government spending picture.

            Still, I'd agree that infrastructure spending by government, for example, is at least as beneficial as consumer spending.

            Since writing the comment upthread, I have looked at some of your other writing, and I must say that I'm impressed with your thinking in general.

            Occupy is the symptom. Fundamental reform is the cure.

            by Tim DeLaney on Thu May 17, 2012 at 07:30:08 AM PDT

            [ Parent ]

            •  Infrastructure spending probably has the best (2+ / 0-)
              Recommended by:
              James Kroeger, Tim DeLaney

              multiplier. Rule of thumb, 100 billion spent will create about 2 to 2.5 million jobs. SO 1 trillion would create 20 to 25 million jobs. And currently U6 is about 14.5%, civ workforce is about 159 million, so 14.5% is about 23 million people.

              We need t spend 5% of GDP (750 billion) on infrastructure, last year we spent 1.3%. Most developed countries spend 5 to 6% of GDP.

              Remember a dollar spent in 1936 stayed in the US, thats no longer true, so a dollar spent in the US would stimulate the global economy. The good news is infrastructure stays put.

              FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

              by Roger Fox on Thu May 17, 2012 at 07:37:05 AM PDT

              [ Parent ]

      •  Government doesn't cut spending equally (0+ / 0-)

        ... in proportion with tax cuts, so the notion is entirely theoretical, unless you can show a clear example and a reason why you'd predict this would happen in the future.

        Government borrowing takes money that might otherwise be put to unproductive uses (e.g in the pockets of the wealthy, not generating useful economic activity, or diverting it from corporate borrowing to finance offshoring jobs) and puts it in the pockets of those who'll spend it through entitlement spending, or employing civil servants, etc.  Some govenrment spending is unproductive (mainly military spending); other government spending promotes a healthy economy in other ways (e.g. air traffic control or infrastructure spending/maintenance).  

        The reason government borrows money is that it doesn't have it through tax revenues or other sources.  It doesn't "have" that money until it borrows it, and spending goes on in any case.  So the rhetorical argument you set up, in which I'm supposedly not-progressive, is pointless.

        When Free Speech is outlawed, only outlaws will have Free Speech.

        by Dallasdoc on Thu May 17, 2012 at 06:44:59 AM PDT

        [ Parent ]

        •  Yes, Doc... (1+ / 0-)
          Recommended by:
          Roger Fox

          ...it is theoretical, just like all of the other assertions you will find in an economics textbook.

          The point of a theoretical exercise like this is to isolate the effects that are caused by certain particular actions that policy makers could choose to execute if they wanted to.  Keep in mind, at no point am I suggesting that government spending be cut to match a tax cut, but you shouldn't be surprised to hear someone like John McCain propose such an idea, since he essentially suggested such a commitment during his losing campaign vs. Obama in 2008.

          So the rhetorical argument you set up, in which I'm supposedly not-progressive, is pointless.
          I really can't fathom what is going on in your mind that you find threatening in some way.  Maybe I'll find a better way to articulate it for you at another time.  
    •  tax cuts in aggregate, or in specific? (0+ / 0-)

      There seems to be variability in the effects of tax cuts as one looks to more specific and less general cases. I'm seeing both contractionary (savers) and expansionary ('good' spenders) effects from a tax cut in the comment above.

      One can make a case for general results across the US, as well as a case for differing results from targeted tax cuts. It seems that a tax cut for a group that is motivated to spend most of it will be expansionary. The small effect of the savers is outweighed by the spenders. Conversely, a tax cut for a group that is motivated to save or invest is contractionary. All saving and little to no spending.

      The Republican view that all tax cuts are expansionary, all the time, would be extremely hard to justify, especially when so much of the money and tax cuts are concentrated in the hands of those with no motive to spend.

      Less "WAAAAH!", more progress.

      by IndyGlenn on Thu May 17, 2012 at 06:29:48 AM PDT

      [ Parent ]

    •  Is it really economically stimulative? (0+ / 0-)
      Agree with you that raising taxes on the wealthy is economically stimulative, because it decreases government borrowing and avoids these costs.
      You're conflating two issues: reducing government debt and allocation of resources.

      Most rich don't keep their money under a bed, it's already risked and invested in the economy in general, in the form of some financial instrument.

      You can reduce government debt by reducing government spending as well. That's less economic activity from the government, but whether it turns out to a net plus or minus depends on what's done with the money that would have had to be collected to maintain services.

      •  Investing by the wealthy (1+ / 0-)
        Recommended by:
        James Kroeger

        ... is often overseas, where it does little or nothing to stimulate the domestic economy.  It also is often invested in assets which collects rents from other economic actors, removing money that might stimulate more activity if spent otherwise (affecting the velocity of money in the economy).  

        Some government spending is economically unproductive, especially in military hardware and overseas installations.  But most other government spending goes to transfer payments or employment, and thus is stimulative.  If you want to increase economic activity by decreasing government spending, cut the military.

        When Free Speech is outlawed, only outlaws will have Free Speech.

        by Dallasdoc on Thu May 17, 2012 at 06:49:36 AM PDT

        [ Parent ]

      •  If one doesnt invest money (1+ / 0-)
        Recommended by:
        James Kroeger

        one is likely to get no return. I thought we learned that in 1937-1938.......

        FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

        by Roger Fox on Thu May 17, 2012 at 07:42:52 AM PDT

        [ Parent ]

  •  Even if every econ book were (2+ / 0-)
    Recommended by:
    Tim DeLaney, spacejam

    100% wrong, how would that affect the thinking of a bunch of people who never read anything but whose economic philosophy is based on dogma and greed? The GOP doesn't believe, due to some theory, that growth is based on tax cuts; they like tax cuts, so they have simply decided that tax cuts are good for the economy. Just like they hate Obama, so they have decided that he is a socialist (which they have decided is something to be hated).

    It's about dogma. Books written by actual academicians or economists have no role in the movement.

    •  I'm sure not trying to convince any Republicans... (1+ / 0-)
      Recommended by:
      Roger Fox
      Even if every econ book were 100% wrong, how would that affect the thinking of a bunch of people who never read anything but whose economic philosophy is based on dogma and greed? The GOP doesn't believe...
      So you think I'm offering a suggestion on how to break the Republican politician of his addiction to greed?  Hardly.

      I'm talking about arguing economic policy in the public arena, where members of the Journalist Class grant authenticity to the laundry list of Economic Myths that the Republican repeat every election.  If the textbooks were corrected and the journalists out there remembered the actual facts about tax policy, then they wouldn't be as likely to give the R's a free ride.

      As things stand now, journalists don't challenge the R. politicians because they remember their econ class textbooks saying the same crap and 'anti-Republican' economists are saying a word about it.

  •  Wuh? (0+ / 0-)
    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.
    How the hell do you hold all the other variables constant?  The government doesn't even control most of the variables.
    •  My advice... (1+ / 0-)
      Recommended by:
      Roger Fox

      ...don't give even a second of thought to taking an economics course.

    •  to isolate - in theory- the effect of one act (1+ / 0-)
      Recommended by:
      James Kroeger

      FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

      by Roger Fox on Thu May 17, 2012 at 07:40:27 AM PDT

      [ Parent ]

    •  Variables (2+ / 0-)
      Recommended by:
      Roger Fox, MGross

      Economic models are generally equilibrium models. That means that they postulate an algebraic system of variables which has a (hopefully) unique solution.

      Some variables (propensity to consume - the proportion of income consumed by the average individual) are usually treated as given, because they represent collective behaviors out of the control of policy makers. We usually call such things parameters.

      Some variables we assume adjust automatically to other values within the system - for example if our model assumes a uniform and constant propensity to consume from current income then consumption is determined by personal income by this linear relationship. We call those variables who value is determined in equilibrium "endogenous".

      Variables that can be chosen directly by policy makers are called "exogenous variables". We take these values to be arbitrary, rather than determined in equilibrium. We typically need some values to be so chosen so that the system has a unique solution. When we do policy analysis - "comparative statics", we compare the equilibrium outcomes assuming different values for the exogenous variables. By keeping the values of most of these constant and only changing one at a time we can isolate the impact of changing just that one variable. In calculus terms we take a partial derivative with respect to that variable (typically this will vary depending on the levels of the other variables so a generalization like tax cuts increase or decrease activity may only hold for some circumstances).

        Usually macroeconomic models take the level of taxation and the level of government spending as exogenous, and view the difference (the deficit) as something endogenous (if it enters the system as a variable at all - not necessary if we already have variables for taxation and spending). Mr. Kroeger seems to feel this is an embarrassing theoretical error or at least a political one, and that we should instead treat spending as an endogenous function of taxation and a fixed budget deficit. As a theoretical matter that is just a question of practicality and custom, the same results obtain for the same choices of taxes, spending and deficit. If in fact the government is setting its taxation and spending policies and deficits are whatever the difference is, then the current approach makes sense. If there was a Balanced budget requirement in place for the federal government as there is for many states, Mr. Kroeger's approach might have some merit.

      As the general context for this analysis is to assess the potential stimulative impact of deficit spending, Mr. Kroeger's claims are really rather silly. While economists are certainly guilty of neglecting the macroeconomic impact of income and wealth distribution in ways that are equally ridiculous especially in the context of analyzing debt driven macroeconomic phenomena, the diarist is not addressing that problem.  It is almost certainly the case that the distribution of taxation has a profound effect on its macroeconomic impact, and that aggregate measures of "taxation" and "spending" obscure those effects. That is the embarrassing error that economists make - and I think it is intentional, either out of fear of being dismissed as nonobjective (mixing positive claims about economic behavior with normative opinions about income distribution) or simply writing apologetics to support rich people having even more money.

      e

  •  I wish that chart went on for a few more years.. (1+ / 0-)
    Recommended by:
    James Kroeger

    then we'd really see that the tax cuts and 2 unfunded wars bought us.  

    Republican marriage is between one man and one woman....plus another woman on the side.

    by Alan Arizona on Thu May 17, 2012 at 07:16:33 AM PDT

  •  Exactly, republished to Keynesian Kossacks (1+ / 0-)
    Recommended by:
    James Kroeger

    FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

    by Roger Fox on Thu May 17, 2012 at 07:30:02 AM PDT

    •  Gee... (1+ / 0-)
      Recommended by:
      Roger Fox

      ...I guess I'm kinda uninformed.

      Keynesian Kossacks, eh?  I like it.

      Thanks for the compliment, Roger....

      •  Well then, If you check your DK message inbox (0+ / 0-)

        there should be a group invite......

        Just guessing here, you might make a good fit...... ?

        FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

        by Roger Fox on Thu May 17, 2012 at 08:48:21 AM PDT

        [ Parent ]

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