Tag Archives: John Taylor

Will The States Really Increase Net Spending If We Send Them More Money?

Ezra Klein writes:

[N]ot all “temporary stimulus spending” is the same. The theory behind a temporary payroll tax cut, for instance, is that it gives Americans a bit more money to spend. But that only gets the economy moving in a significant way if Americans are sufficiently interested in spending that money. The argument against a temporary tax cut is that Americans know it’s temporary and they know that they will eventually have to pay for this sort of spending and so they save the tax cut rather than spend it.

In contrast, Klein believes a new proposal by Senator Reid would lead to more net spending. That’s because instead of channeling the money to taxpayers who might save it, the Reid proposal would channel it to state and local governments who will surely spend it.

The problem is that John Taylor and John Cogan have convincingly shown that in the last stimulus, despite Keynesian hopes, the state and local governments didn’t use the extra money to increase their net spending. Instead, they used it to decrease borrowing.

In other words, the federal government borrowed and transferred hundreds of billions of dollars to the states which used the money to reduce their own borrowing, largely offsetting the federal increase in borrowing. In the end, little if any new purchasing power was created or advanced through time.

It isn’t clear to me why we should expect anything different this time around.

“Where are the jobs from the Bush tax cuts?”

So asked Senator Franken (D-MN) in a press conference this week.

It is a good question.  From 1981 through 2000, real GDP grew at an average annual rate of 3.3 percent.  But from 2001 to 2008 (even before the Great Recession began), real GDP grew at only 2.1 percent per year.  Why did growth seem to slow after the Bush tax cuts?  There are a number of different plausible answers.  I’ll take a stab at two:

1.  Yes, all things being equal, some people believe that a deficit-financed tax cut should improve the economy.  But all things were not equal in the 2000s.  In just about every aspect other than taxes, economic policy in the 2000s moved in an anti-market direction.  One could cite monetary policy as John Taylor does.  One could cite regulatory policy as Mark and Nicole Crain do.  One could cite trade policy.  One could cite the increased reliance on counter-cyclical stimulus efforts (there were 4 such packages during the Bush years).  Lastly, one could cite the large increases in spending that attended two wars, the prescription-drug benefit, the farm bill, and other policies.  Indeed, according to the broadest measure of economic freedom over time, the “chain-linked” EFW score by Gwartney, Lawson and Hall, U.S. economic freedom steadily improved up until around 2000, whereupon it precipitously fell:

2.  Another reply might be: we didn’t have a tax cut.  By this I mean that a tax cut without a spending cut is not a tax cut; it is a tax deferral.  When I wrote earlier that some people believe that a deficit-financed tax cut will improve the economy, I linked to John Maynard Keynes.  This is because Keynesian models predict deficit-financed tax cuts will spur economic growth (they also predict that deficit-financed spending increases will spur growth).  But there are other schools of thought.  One theory holds that if uber-rational, forward-looking consumers know that Deficits Are Future Taxes (Professor Mike Munger uses the helpful acronym “DAFT”), then they will save for those taxes today, which means that they won’t spend, completely offsetting whatever government spending that the deficits pay for.  But as I’ve explained in a previous post, you don’t need to believe in such an extreme model of human rationality to arrive at the conclusion that deficit-financed taxes will fail to spur growth.  This is because deficits lower the nation’s capital stock, which over the medium-to-long-run also harms economic growth (see the link for more details).

The bottom line: Though he almost certainly didn’t intend it this way, Senator Franken’s observation that the Bush years were not massive growth years actually bolsters the case for both spending cuts AND tax cuts.