×

Fill out the brief form below for access to the free report.

  • George W. Bush Institute

    Our Ideas

  • Through our three Impact Centers — Domestic Excellence, Global Leadership, and our Engagement Agenda — we focus on developing leaders, advancing policy, and taking action to solve today’s most pressing challenges.

I'm interested in dates between:
--

Issues

I have minutes to read today:

Programs & Issues

Issues

Publication Type
Date
I'm interested in dates between:
--
Reading Time

I have minutes to read today:

Once Again, There's No Free Lunch

February 13, 2013 7 minute Read by Ike Brannon

The president seems to be holding most of the cards in the negotiation to resolve the so-called fiscal cliff. If no deal is reached by January 1 (as now seems possible), the Bush tax cuts in their entirety will expire. This means that millions of people currently not paying federal income taxes will go back on the tax rolls, and the rates on everyone else will go up, as will the tax rates on inherited income, capital gains, and dividends. The president has said that he just wants rates to go up on those earning over $400,000, which isn’t terribly unpopular among the 99% or so of the population with incomes below that level. However, in a tacit acknowledgement that such a change would have some sort of an impact on economic growth — and an acknowledgement that we’ve already gone through three years of tepid economic activity — in the final package the president wants to include some immediate stimulus spending on various infrastructure projects. Setting aside the question of how such a tax change would impact the economy, the unasked question thus far has been whether there is any reason to think another injection of government spending would goose the economy. A recent paper suggests that the answer is an unambiguous and emphatic “no.” Jason Thomas, director of research at the Carlyle Group — and the last Republican economist the New York Times ever praised when it acknowledged his prescience in sounding the alarm over the financial crisis in the Bush White House — suggests that both parties fail to grasp the fiscal constraints that the large and growing debt places on fiscal policy. The Keynesian rationale for government spending is that it increases growth in the short run during times when there is unemployed labor and capital. The theory contends that during recessions the government can borrow money without substantially crowding out private investment by pushing up interest rates. When money is just sitting in the bank unproductively, Keynesian theory tells us that the government should spend it productively, pushing the economy closer to its potential output level and making us all better off. There’s no disputing that there is a lot of money sitting on the sidelines at the moment:  Banks and financial institutions have been reluctant to lend over the past four years, partly because of a retrenchment encouraged by banking regulators and partly as a response to the uncertain economy we’ve been suffering through. The Keynesian line of thinking is an appealing story to be sure, but unfortunately not one that resembles how the world really works. In his paper, Thomas — setting aside the argument that government simply does not have the ability to spend money quickly or productively — asks how people respond to an increase in public borrowing. What Thomas argues is that people demonstrate a bit more foresight than the Paul Krugmans of the world give them credit for, and that in a world of seemingly unending trillion dollar deficits, people rationally anticipate their taxes will be increased sometime in the near future. Thomas’s argument is not a new idea: Economists call this “Ricardian equivalence,” meaning  that whether a government finances new spending via taxes or by running a bigger deficit, the impact on the economy (or to be more precise, on aggregate demand) is the same. If a government constrained to maintain a balanced budget decides to increase spending, it needs to increase taxes, which means that taxpayers will see their tax bill go up and accordingly spend less. In this way, government stimulus merely crowds out private investment. A government not constrained by a balanced-budget requirement — such as the U.S. federal government — can carry a deficit. Ricardian equivalence states that people will anticipate higher future taxes as a result of government borrowing, and they’ll set aside more money to save for that eventuality. Therefore, government spending crowds out private spending here as well. There is no free lunch, and people know it. There’s a lot of evidence to support this. For instance, savings rates jumping up in the nadir of the great recession seems non-intuitive until we consider the unprecedented leap in the deficit. Of course, this also goes in the opposite direction: Increasing taxes to plug a deficit may not necessarily dampen economic demand all that much, since people have been anticipating just such a scenario. Those of us who believe strongly in the primacy of economic growth do not care a whit about how or whether tax policy affects aggregate demand. Rather, we worry about how much a tax-rate increase will impact aggregate supply, or the amount of investment in plant, equipment, and human capital. Far be it from me to suggest how the fiscal cliff will be settled. But it seems clear at the moment that tax rates will be going up for people near the top of the income distribution and that we’re likely to see a boost in taxes on capital income. The Republicans appear to hold few cards to stop this from occurring. But I do hope they fight the Administration’s desire to slip in a few hundred billion dollars of “investment” to boost economic growth, since this will actually have a depressing effect on the economy. The real way to get growth is for both parties to commit to a genuine dialogue about how to restructure the tax code to encourage the private sector to invest more and to reform our entitlements so we can get lower deficits — and with that, more money for those things the government truly needs to do.


Author

Ike Brannon
Ike Brannon

Ike Brannon served as an Economic Growth Fellow of the George W. Bush Institute from 2012 to 2015. He has a Ph.D. in economics from Indiana University and a B.A. in math, Spanish, and economics from Augustana College. View his full bio

Full Bio