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Wednesday, July 21, 2004

Battle Tax Cuts - Challenger - Second Rebuttal

Shorter Dan:

"The Great Pumpkin will come down and pay off the deficit. And the people who don't believe in the Great Pumpkin are just desparate liberals! Like those Republicans in Congress who projected deficits for the next 10 years, just liberals I tell you!"

Some on the right might be inclined to agree with Dan on that point. That CATO institute points out:

The new estimates show that, under Bush, total outlays will have risen $408 billion in just three years to $2.272 trillion: an enormous increase in federal spending of 22 percent. Administration officials privately admit that spending is too high. Yet they argue that deficits are appropriate in times of war and recession. So, is it true that the war on terrorism has resulted in an increase in defense spending? Yes. And, is it also true that a slow economy has meant a decreased stream of tax revenues to pay for government? Yes again.

But the real truth is that national defense is far from being responsible for all of the spending increases. According to the new numbers, defense spending will have risen by about 34 percent since Bush came into office. But, at the same time, non-defense discretionary spending will have skyrocketed by almost 28 percent. Government agencies that Republicans were calling to be abolished less than 10 years ago, such as education and labor, have enjoyed jaw-dropping spending increases under Bush of 70 percent and 65 percent respectively.

My case against the tax cuts has been that first, they were not stimulative, second they have driven investment demand without investment supply, and third they were coupled with a supply-side fiscal policy, namely the war on Iraq, whose outcome has failed to produce the expected gains. Therefore, the tax package, rather than being extended, as is now being planned in Washington DC, should be abandoned, and a different policy regime put in place. Whether the American people chose different leadership to make this change is a question that can only be answered on election day, and will be based on the positions of the candidates themselves.

Dan's repetition of "give people more of their own money" is, an argument that "demand creates its own supply". This was the argument of classical Keynesian economics, that up to full employment, the government could stimulate the economy without adverse effect. The public knows the unravelling of this doctrine by two words: Jimmy Carter. What is happening now is that the same problem Carter had with the Keynesian consumer program: namely that more money was pushing on a string. This means that more demand, in the form of upper bracket tax cuts is not finding new supply. Even Microsoft is admitting this, as it starts a multi-billion dollar pay out. They don't have any place to put the money.

To see why reducing marginal tax rates on capital gains worked in 1982, and does not work today, it is useful to look at the following chart:

In 1982 the market was willing to pay around 9 dollars for a dollar of future earnings. The investment sector was badly deflated, and therefore reflating it - with marginal tax rate reductions - worked. Now look at the right hand side of the graph: the story is completely different. Earnings are historically expensive. To get economic growth from the investment sector would require that the 1990's boom starts again. Yesterday. That is not happening.

What this means is that pushing money to the upper income brackets, favoring dividend payouts, sheltering estates from taxation, all generate investment demand. But this investment demand is not creating new businesses. No matter how many times Dan repeats "giving people their money back", demand still does not create its own supply when supply is saturated. Right now, the supply of new chances to make money is saturated.

Some of asked whether any "stimulative" deficit would have had the same result. If pure stimulus had been the objective, then Congress could have simply passed something along the lines of:

  1. Max Sawicky's Simplified Family Credit. Which in its most generous form would cost $80B according to the plans author.
  2. Extended Unemployment Insurance to 12 months. Which would have been $20, extrapolating from these Republican figures.
  3. Slashed the 10% rate down to 0%. Which, extrapolating from the Senate Joint Committee on taxation would be $200 Billion.
  4. Increased the per child tax credit, while maintaining eligibilty for the full credit, which was removed from the 2003 tax act. Net cost is estimated at $35 Billion based on the Grassley Bill.

Total cost including interest? $400B, which is to say, almost $2Trillion less than the total of the tax package that was passed. This would have meant that all taxpayers would have had their Federal Income Tax payments reduced by $715, and taxpayers with children, all of them, an additional $400 per child. The Republican's own sweet spot family, their best case, would receive, not $1132, but $1515. The benefit of this is that it would have gone directly to economic stimulus, rather than merely going to primp up corporate profits. I'm not endorsing this particular tax plan, merely outlining what a standard stimulus side package would look like. In outline this bears some similarities to the separate tax plans put forward by General Wesley Clark in his campaign, and outlined by Franco Modigliani.

This would have meant that almost every US taxpayer would have gotten $715 dollars back, and another $400 dollars per child. It would have had a considerably smaller impact on the deficit.

But to return to the central point. More money creates more demand, but it does not necessarily create more supply. Government can only push stimulus when there is "slack capacity". If there is high unemployment, the government can borrow money, and employ people until private employment demand picks up. If there is slack capital, then the government can pursue projects until the capital is absorbed. But what it cannot do is with demand side policies, and tax policy is a demand side policy, is create supply where there is no spare supply. This a lesson that lawmakers, left and right, consistenly want to avoid learning: demand side policies from the government can only bring the economy up to its best level of economic performance. It cannot make the economy perform better than it is capable of performing.

To create real growth requires supply side policies, policies which are not in any way enshrined in this particular tax package. The government can do its part to create new supply: education, research, infrastructure, trade agreements and promoting spin offs of technology - such as the internet - are all supply side. Government can force, in the short term, conservation policies which allow the economy to get past a short term squeeze in supply, but this, like fiscal stimulus, cannot be maintained without distorting the market for goods. Ultimately, the government can provide the playing field, but the free market must provide the game, and the spectators. And this is one of the reasons why many conservatives are critical of this Executive's spending binge.

This is why it is important, when creating demand side policies to understand what the supply side problems in an economy are, before crafting the tax legislation. The Bush tax plan, and its defenders, have made no effort to show how the almost 2 Trillion dollars of cost in this package will produce new investment supply. They have merely asserted that investment demand will produce its own supply automatically. This has clearly not been the case, instead, what has happened is that investment demand has been profitized, which has meant stagnant family income. Government tax rate reductions cannot change this picture long term, they can only borrow from future production to pay for the present. If done correctly, the government borrows, and runs a deficit, during times when labor is inexpensive, and then pays the money back later by taxing asset inflation. This was the Truman, Eisenhower and Clinton policy, and it was Carter's intent, however badly he mismanaged the execution. This is the real "growth" win, spend into deflation, tax into inflation. But to do this requires that the period of borrowing be, as the graphy in my previous post shows, of short duration and targetted to slack capacity in the economy.

In my first post, I argued that there are two import bottlenecks to growth which have to be addressed on the supply side, one is energy, and the other is investment opportunity. The two are related. Energy inflation has reignited. This means that more demand side policy will simply mean a weaker dollar and higher oil prices, which is exactly what has happened. The other side of the equation is that real wages are stagnant, with increases in oil, health insurance leading the way.

Without addressing the supply side problems, more demand will simply produce more asset inflation. This is already being met with higher interest rates from the Federal Reserve, which is going to increase the cost of all borrowing in general. According to the CBOT bond yield curve, the fed funds rate is expected to reach 2.75% by early next year, adding 1.5% to the cost of borrowing on mortgages, credit cards and car loans. The fiscal policy of rate reductions is now fighting the monetary policy. Advise to lawmakers: don't fight the fed.

The Bush economic program as a whole has not done anything to address this supply side problem, other than invading Iraq and promising cheap oil. And no, drilling in ANWR will not be the "solution", it has a mean estimate of 5.24 billion bbls. To give you an idea of the scale, there are some 112 bbl known to exist in Iraq, and some 200 bbl which might exist with further exploration. Some 60 times ANWR. Iraq was the only supply side policy of any scale that has been pursued by the current executive. It was, essentially, a trillion dollar gamble that military force could be converted into oil supply. This is not the first time this gamble has been made. In the 1920's the British made it, and won, they occupied the Middle East and drew the boundaries for present day nations, including Iraq. In late 1941, facing an oil embargo from the US, the Japanese made it, and lost. In 1991, the US made the gamble that it could prevent supplies from falling into Saddam's hands, and won.

The logic, that Iraq was the only easy source of more oil supply, but that Saddam could not be trusted with unlimited oil revenues, which would total tens of billions of dollars a year, was compelling to many across the political spectrum. Containment had not failed to contain Saddam, but it had failed to make him an individual with which the US and other nations could safely do business. This is why there is such emphasis now in rhetoric about the "possibility" of Iraq pursuing WMD later. The real power equation, and this is said not as an attack but as a fact of realpolitick, was that for the US to slake its energy thirst, and go back to easy growth, Iraq had to be opened. Iraq could not be opened with Saddam in charge. That the excuses for launching the war have turned out to be fabrications, and the cost of the war grossly misestimated, are not germane to what the gamble was based on. They are important for asking the question of whether, given honest information, the US would have chosen this particular course. But practically, that is a matter for PhD's in history to argue when we are dead.

However, having made this gamble and lost, the US is now in the position of having borrowed against success, and having found failure. Perhaps more than a few legislators rue not listening to Greenspan's warning that tax reductions should be made contingent on surpluses materializing. That is, that the tax reductions be true PAYGO tax cuts.

That there is no connection between the tax policy demand side and the supply side problem is now a widdening flaw in the tax package. Since the tax package was dependent on the success of "another Saudi Arabia" coming on line, it does not stand by itself. Unlike the Reagan capital gains marginal rate reductions, which connected to the supply-side by reflating the investment sector, and the Kennedy marginal rate reductions, which connected to the supply side by reducing the incentives to shelter income - there is no road in the massive Bush tax rate reductions to reach the supply side. No new supply means localized inflation. Since, as everyone admits, the tax package benefits those with a "marginal propensity to invest" rather than spend, this means continued asset inflation. Asset inflation, or a stock market bubble, means that capital will be inefficiently distributed, primarily being disbursed as dividends without producing any improvment in capital. In short money goes from the Treasury, to corporate profits, to dividends, without making any productivity improvments. This has lead to real wages falling to a two year low.

In summary: demand side policies must either be coupled with supply side policies to remove bottlenecks to growth, or be focused on areas where there is already surplus supply. The tax package does not, by itself, target areas of the economy needing more demand, and the supply side project of invading Iraq has not produced the expected oil windfall. Hence the tax package is merely inflating the deficit, pressuring up long term interest rates, and creating short term asset inflation, which hinders business formation and job growth. As a failed policy, it should be abandoned. If current leadership cannot admit that it is a failed policy, as some seem inclined to attempt, then the Constitution provides a remedy at the ballot box.


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