The Keynesian policy of trying to increase total i.e. “aggregate” demand – either by having government spend, or by cutting taxes just to leave more money in people’s pockets in hopes that they’ll spend – to revive the economy, never works. The latest installment of Keynesian failure is the payroll tax cut.
Predictably, like its predecessors, this “stimulus,” which aimed at putting money in people’s pockets, failed. The economy was unmoved, and indeed appears now to be slowing again, as today’s bleak jobs report underscores.
This wasn’t the first time Keynesian stimulus failed to stimulate. Let’s recall that Keynesianism failed to revive the economy from the Great Depression, during which government spending increased throughout the 30s, yet unemployment remained in double-digits; it failed in 2001 when President Bush attempted to stimulate the economy out of recession by putting money in people’s pockets through a series of tax rebates; it failed under President Bush a second time in 2008, when government spent hundreds of billions of dollars; then it failed in 2009 under President Obama, after we spent the largest sum of money in the name of Keynesianism – some $800 billion – in order to revive the economy. The one thing you can say for Keynesian stimulus is that it is bi-partisan – it fails for Republicans as effectively as it does for Democrats.
Despite having always failed, lawmakers agreed to try the Keynesian method yet again at the end of 2010. The agreement reached in mid-December was that in exchange for not raising taxes on the wealthy, a “stimulus” of a one-year, two percentage point cut in the payroll taxes paid by workers, would take place starting January 2011.
Extending the Bush tax cuts for the top two income brackets was certainly no stimulus, either. Nor was it intended to be. No tax rates were reduced. Rather, blocking those rates from increasing prevented a tax hike from weakening the economy further.
According to a recent post on the issue:
The BEA reported that its first estimate of 1Q2011 real GDP growth was 1.8%. This represented a dramatic fall from 4Q2010 growth of 3.1%. . In 1Q2011, this stimulus amounted to about $110 billion on an annualized basis, or about 0.73% of GDP. Given the Keynesian belief in “multipliers”, the result should have been to increase 1Q2011 real GDP growth significantly over that of 4Q2010. Instead, the real growth rate fell, thus providing one more real-world confirmation that Keynesian stimulus doesn’t work.
This is no surprise. Keynesian stimulus policy is built on the assumption that government spending has a multiplier effect through the economy, meaning that $1 spent by government adds more than $1 to total national income. The mistake is in ignoring the fact that in order to raise money for government to deficit spend, government must first remove that money from the private economy through borrowing, resulting in an equal multiplier reduction. The two sets of multipliers cancel each other out. There is no net increase in total demand.
The same logic applies to Keynesian-style tax cuts aimed at putting money in people’s pockets: If government doesn’t increase spending but cuts taxes instead, it still must borrow money from the private economy to finance its current spending levels. Thus, removing money from the economy in order to finance the cuts leaves total demand unchanged.
Nevertheless, while tax cuts to raise aggregate demand are ineffective as economic stimulus, the right kinds of tax cuts can be stimulative. Stimulative tax cuts must lower tax rates on economic activity at the margins – the tax rate on the last dollar earned – as that’s where drivers of the economy make decisions about investment and work effort. And the cuts must be permanent.
For example, if someone’s income is high enough that he or she is subject to the 35 percent tax bracket (currently the highest individual rate), then he or she will pay $35 on the next $100 earned. If that rate is cut to, say, 25 percent, then that person will pay $25 – earning $10 additional dollars – on the next $100 earned. The incentive is then greater to create an additional $100 of wealth.
Though the 2001 tax rebates aimed at raising demand failed to revive the economy, marginal tax rates were cut on individuals. Originally these cuts were to be slowly phased in until 2010. However, in 2003 they were accelerated, and dividend and capital gains tax rates were also cut. That’s when, not coincidentally, the economy took off.
Today, examples of where this type of tax cut would stimulate the economy include the corporate and individual income tax rates, as well as capital gains and dividends tax rates. Cutting any or all of those rates would spur work effort and investment, just as they did in 2003. Of course, given current budget deficits, cutting taxes is especially difficult, which is another unfortunate consequence of the massive Obama stimulus – it made effective stimulus harder to enact. In fact, The Congressional Budget Office just announced that the Obama stimulus actually raised the deficit by $840 billion, far more than originally projected.
Even a payroll tax rate reduction would help, not because it increases families’ cash flow, but because it gives those who have the opportunity to do so more incentive to work and produce. Unfortunately, even this effect was largely erased from the payroll tax cut President Obama championed, because his payroll tax cut was temporary. Temporary tax relief of almost any kind produces few growth benefits.
Proponents of the recent measure reply that Keynesianism has never been tried strongly enough. After all, in addition to arguing that New Deal spending wasn’t big enough in the 30s, they’ve argued that President Obama’s stimulus wasn’t big enough. Just wait for their claims that this latest payroll tax cut “stimulus” wasn’t deep enough, either.
At what point can we officially put a sword through that argument and bury the concept of a Keynesian fiscal stimulus? Probably until the next recession that occurs during an administration wedded to spending and repelled by rate reductions.