The main critique of fiscal policy is the debt burden it places on future generations. It is undoubtedly a huge social cost which does mean the governments of the world need to have a medium and long term fiscal strategy, whereby government expenditures recede, tax revenues increase and the budget moves into surplus. What one must look at is how fiscal stimulus actually reduces the debt burden as it closes the deflationary gap and allows recovery of tax revenue and fiscal retrenchment once the economy is on a self-sustained up swing. This is the concept of dynamic scoring.
Another way to look at dynamic scoring is to note that a particular increase in the deficit of say $X B does not necessarily increase the national debt by $X B in the long run. Deficits lead to increased output and a recovery in taxation revenue as automatic stabilisers kick in. The Keynesian argument expressed in my first post on fiscal stimulus suggests that deficits are ‘self-financing’, in terms of creating a pool of private savings to offset the reduction in government savings. What one must appreciate is how the concept of dynamic scoring has implications for the relative efficacy of government spending and tax cuts.
Krugman illustrates this by back-of-the-envelope calculations, and uses the formula ,
where t is the marginal tax rate. Note that the simple multiplier can be used because interest rates are assumed to be fixed (a fair assumption) With estimates such as MPC=0.5, and t=1/3, we obtain a multiplier of 1/(1-(1/3)) = 1.5. This means for an increase in $100B of government spending, we have an increase of $150B in GDP. From the $150B increase in GDP $50B is collected in taxes (due to t=1/3), and a ‘bang for buck’, that is, the amount of increase in GDP per dollar of the future deficit is 3 (As the future deficit is $50B, and 150/50=3). Thus the recovery of half of the lost revenue comes via increased incomes resulting in increased taxation revenue. It is interesting that dynamic scoring increases the gap between those who prefer infrastructure spending and those who prefer tax cuts. According to tax cuts, the multiplier is ,
which for MPC=0.5 and t=1/3 is 0.75. Furthermore, given the example of a $100B tax cut, we have an increase in GDP of $75B, and a $25B taxation revenue gain. Thus, the ‘bang for buck’ is only 1, compared to 3 for Government purchases. What this example shows, is that even with a low MPC, Keynesian theory supports deficit spending as the burden on future debt is minimised via taxation revenue recovery from increased incomes.We have looked at the Keynesian version of dynamic scoring, which claims the ‘bang for buck’ promoting the claim for government spending rather than tax cuts. However, other proponents of dynamic scoring claim that tax cuts are more conducive to growth.
Some aspects of tax cuts being conducive to growth were touched on in my previous post. The central idea of tax cuts is to stimulate investment and increase incentives to work, save and invest, and by changing the relative prices of capital, it encourages a re-allocation into more useful capital. These incentive effects were completely neglected by Krugman’s analysis of ‘bang for buck’ illustrated previously, and it is still open to debate whether tax cuts can lead to greater output effects in the long-term.
A treasury study on the $3 Trillion Bush tax-cuts have found that 20% of the package, which comprised of cuts in capital gains and dividend taxes, led to over half of the economic growth effects. Cash transfers to low-income households, child credits and marriage-penalty relief had negligible incentive effects, and in fact, the treasury predicts higher growth without such tax cuts! Thus it is obvious that the theory of incentive effects of taxes is contingent upon the type of tax. It seems that a consensus on the best incentive effect tax cuts seem to be tax cuts aimed at reducing the cost of capital directly, like capital gains tax, and this is partially because it favours higher-income households. For example, in a survey Stiglitz concludes:
“Pareto efficient taxation requires that the marginal tax rate on the most able individual should be negative…”(Stiglitz)
Thus many believe that marginal tax rate reductions have more incentive and supply-side effects if they are targeted at higher income deciles, contrary to vertical equity and the progressive taxation system.
A more important finding of the treasury report is that the effect of tax cuts is contingent on how it is financed. If it is not financed via immediate reduction in Government spending, than it is assumed in treasury analysis to be financed via an increase in future income taxes. Then we are hit by a deadweight loss of future taxes, as well as Ricardian equivalence measures- of absorbing the tax cuts into increased savings, with no change in consumption, could significantly reduce any demand/output effects. GNP estimates suggest that in the case where tax cuts are financed via reduced G- there is a 0.7% increase. In the case where tax cuts are financed by future increased taxes, there is a 0.9% fall. This disparity reflects the fact that tax cuts cannot be temporary, simply because
i) Temporary tax cuts, if forseen by households, will require them to (in aggregate) purchase government bonds equal in present value to the future tax liabilities from the increased deficit. This will require households to save the full amount of the tax cut, leading to no change in present consumption. This is in perfect ratification with the permanent income hypothesis, which says that consumption trends can only be influenced by permanent changes in income, not temporary changes.
ii) Any reversal of tax cuts will incur a deadweight loss, due to negative incentive effects. In a sense, the tax cut reversal will reverse any growth created by incentive effects, and ruins the dynamic benefits of tax cuts incentivising investment.
Given that tax cuts at present, in Obama’s fiscal stimulus package, are concurrent with even larger government spending increases, this will tend to reduce the effect of tax cuts. This is yet another reason for the Romer-Romer analysis of exogenous tax cuts to fail in light of current circumstances.
It is interesting that the temporary vs permanent concept, a concept outlined in my previous post, provides a powerful argument in favour of government spending. Given that we have proven permanent tax cuts are more effective that temporary tax cuts- simply because it avoids Ricardian equivalence problems, there are numerous problems of maintaining permanent tax cuts, namely, why should we maintain low taxes once the economy returns to normal? Do we permanently cut taxes again once there is another recession? Permanent tax cuts are impractical, temporary tax cuts are ineffective- and given the need to finance the treasury debt via future raised taxes, any dynamic effects of lower taxes will be offset. However, it is possible to make a permanent tax cut work- given that it is financed via a permanent increase in a different tax. Thus Mankiw’s idea of a permanent reduction in payroll tax with a gradual, permanent increase in the gasoline tax is a good idea, with the gasoline tax increasing gradually to enable net output effects from the payroll tax reduction.
Let us examine government spending. If a program requires $100B of government spending each year, consumers may save an amount equal, in present value, to the accumulated deficits, leading to an offsetting reduction in consumption. It is temporary government spending that avoids Ricardian equivalence, as
“…rational households would realise that the increase in their lifetime tax bills would be quite modest, which would imply a small reduction in consumption demand relative to the large increase in government purchases.”(Econospeak)
This shows clearly that there is offsetting consumption, but it is only marginal in light of the fact that the tax burden can be spread across a number of years, thus the offsetting consumption can be spread across a number of years as well. Government must be careful that current projects do not lead to a stream of future projects due to political lobby groups. It is very easy for a temporary increase in Government intervention to become permanent, and this will have disastrous implications for the treasury debt to GDP ratio, which will lead to a more tax-intensive economy in the future.
Dynamic scoring is integral to appreciate the long-term effects of the stimulus package. Through using simple Keynesian analysis, it favours government spending as providing much more ‘bang’ per dollar of future deficit, it is possible that incentive effects of taxes can lead to economic growth, with the increase in GNP leading to a recovery of tax revenue. There are numerous problems with consolidating the incentive effects theory, such as trying to find the relative elasticity of labour demand and supply, to isolate the effect of revenue recovery due to the tax cuts from other variables, the fact that it is contingent upon the type of tax cut- the way the deficit is financed, all of these factors make it very hard to evaluate the dynamic effects of tax cuts. In so far as tax cuts are more easily and readily implemented, they are useful. However, I feel that the first priority is government spending that meets the cost-benefit test, the remainder going towards a well-structured tax cut program, with specific details as to how increased taxes will be implemented in the future without a distortion of the incentive effects created by the tax cuts.
No comments:
Post a Comment