While the proposed tax bills will have a significant impact upon your
personal budget, it will also have potentially important effects on the
economy as a whole.
At the end of last week, the House of Representatives and the Senate
each passed different versions of a tax reduction bill. Today Clinton threw
a third option into the mix. The job now is to reconcile the two bills
with one another and negotiate with the Clinton Administration to try to
create a bill acceptable to all three. Clearly, the resulting bill will
include some tax cuts, most likely something between the Senate’s $85 billion
cut and the House’s $135 billion cut. The cuts come mostly from a $500
per child tax credit and a reduction in the capital gains tax (although
this component is potentially grounds for a veto).
What’s wrong with this picture: the economy is doing
well and Congress passes a tax cut? But wait, whatever happened to
counter-cyclical policy? Keynesian economics suggests that to stabilize
the economy we should raise taxes and/or lower spending in booms, and do
the opposite in recessions. Theoretically, not only will this help to lessen
the troughs and level the peaks, but it will also lead to a budget that
is balanced on average over time – deficits in recessions, surpluses in
booms. The Congress and the President seem to be heading in the opposite
First: The tax reduction need not fly in the face of responsible fiscal
policy. It could be the case that the economy is doing well now, and is
forecasted to do very well in the future. The permanent level of taxation
thus could then be lower than it is currently (since the social support
demands on the system are lower and the government is taking in more revenue
through higher incomes). In this way, reducing taxes now is a way of adjusting
to a new economic environment in which the desired level of federal spending
Second: If we look to politics as a guide, the Congress seems to be
behaving as if there were an implicit Balanced Budget Amendment (with a
no-surplus provision). If we were to take the current bill and remove the
tax reduction components, the deficit would fall by the $85 billion, thus
creating a surplus by the year 2002. Congress, however, seems to have an
incentive to splurge on the extra cash generated by the booming economy
reduce taxes – bringing the deficit to exactly zero. The destabilizing
anti-Keynesian effects of a Balanced
Budget Amendment are well known.
Where have all the Hawks gone?
With the economy doing well, it seems like almost an easy task to balance
the budget. When we extend that rosy forecast in to the future, the booming
economy naturally raises the amount of income received through taxes and
reduces the demand on social support programs.
But what of an economic downturn? Unless economy is expected to continue
on its current path into the indefinite future, deficit Hawks should be
squawking for a projected surplus down the road.
See a past feature on the role of economics forecasts: Economic
Assumptions and the Balanced Budget Agreement.
Still Hope for Keynes… The Fed to the Rescue
While Congress is standing Keynes on his head, the Fed can play the
monetary policy trump card. Many have written off active fiscal policy
as a tool for counter-cyclical policy. This conclusion followed from an
acknowledgment that the politics of fiscal policy formation usually create
too much of a lag between the need for fiscal action the enactment of law.
The Fed, however, is largely immune from the typical political delay, and
the effect of policy actions take place in a (relatively) timely manner.
So if the Congress is ignoring Keynes, perhaps they are doing so for
a good reason. A third theory: the fed may simply be neutralizing the economic
effects of fiscal policy, relieving Congress of the job of managing the
The loudspeaker at the Capital announces:
Keynes has left the building.
Keynes has left the building.
Theory of Employment, Interest and Money by J. M. Keynes.
News stories on Tax bills in the Senate
and House, and
Both. News story
|Sidebar #1: The Economy |
Here’s a quick look at the state of the economy: GDP growth at 5.9%,
|Distribution||A capital gains tax reduction would disproportionately|
benefit households at the upper end of the income scale.
|The majority of the benefits|
would go to households making between $20,000 and $75,000 a year.
|Both are right. Each super-rich|
individual will make out very well (saving $80,000 on every
million in realized cap gains). However, there are more families in the
lower tax brackets meaning that as a group they will receive the
bulk of the benefits.
|Growth||Higher growth is not necessarily shared by|
everyone (like in the 1980’s).
See Distribution (I)
|A reduction would mean more savings and higher|
growth for the economy.
|(Dems) Even though not everyone|
gains from economic growth – most are hurt by a stagnate economy.
(Reps) By all serious accounts the growth effects are very small. To
the extent that it adds to the deficit it may hurt
(Both) Alan Greenspan – a.k.a. the “gate-keeper of economic growth”
– needs to be consulted about the possibility of higher growth.
|Philosophy||Taxes can be fair.||Taxes are always bad.|
|Taxes are sometimes bad and should|