Arnold Kling  

Economists' Voice on Fiscal Policy

Social Security Myths... Cost of Health Care Regulation...

The second issue of The Economist's Voice has appeared, and it looks more interesting than the first.

Several articles discuss fiscal policy. William G. Gale and Peter R. Orszag write,

Looking beyond the next decade, the budget outlook grows steadily worse. The costs associated with retirement and health programs mount. Over the next 75 years, the nation’s fiscal gap amounts to about 7 percent of GDP.

The main drivers of this long-term fiscal gap are, in order, the spending growth associated with Medicare and Medicaid, the revenue losses from the 2001 and 2003 tax cuts, and increases in Social Security costs...

Granted, projected increases in Social Security costs eventually exceed the size of the tax cuts. But do not conclude from this that the tax cuts are less expensive than the Social Security increases. In fact, the reverse is the truth.

The increase in Social Security costs mounts gradually as America ages. In contrast, the cost of the tax cuts starts immediately, and changes little as a share of GDP over time. So in present value, the actuarial deficit in Social Security is only one-fifth to one-third the cost of the tax cuts over the next 75 years.

In a political speech, George Akerlof says,

we have had a permanent massive change in the fiscal circumstances of the country, but, at the same time, we have not even been able to engineer a robust recovery out of the current recession...

The tax cuts were passed with another fiction. That fiction is that the deficit poses no serious threat to social security. The reality is that social security is threatened. And, cuts in social security would be a serious problem.

On the other side, Michael Boskin writes,

From 2001 to 2003, the standard measure of short-run fiscal stimulus, the change in the cyclically-adjusted budget deficit, went from a surplus of 1.1% of GDP to a deficit of 3.1% of GDP, over a 4% swing. This was one of the largest and best-timed uses of fiscal policy in history, helping to prevent a much worse downturn; but it would have been better still if the tax rate cuts had been immediate and real spending controls enacted simultaneously to take effect well into the economic expansion.

In my book, I argued along similar lines. Concerning the widespread criticism of the Bush tax cuts, I wrote

Orthodox Keynesian policy in a recession would be to cut taxes. The Bush Administration has done that. Orthodox policy would be to increase government spending over what had been planned. The Bush Administration has done that, too. When a student hands in an exam that repeats almost exactly what the professor was saying in class, but the student still gets a low grade, then one can only conclude that the professor has something personal against the student.

For Discussion. Was the cyclically-adjusted deficit during the first Bush term too large, too small, or about right?

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The author at Catallaxy in a related article titled A fair question writes:
    Arnold Kling asks a good question about President Bush, the Keynesian:Orthodox Keynesian policy in a recession would be to cut taxes. The Bush Administration has done that. Orthodox policy would be to increase government spending over what had been pla... [Tracked on October 27, 2004 4:11 PM]
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rvman writes:

The Keynesian policy prescription is temporary tax cuts and spending increases. Bush is pushing for permanent tax cuts, and everyone knows all government spending increases are permanent, with the POSSIBLE exception of military ramp-ups during wars like WWII. This, and the (R) after Bush's name, is the problem with Bush's economic policy in the eyes of Keynesians.

My policy prescription is elimination of most to all deductions and tax credits, lower tax rates across the board, identical treatment of labor income and inflation-adjusted interest, dividend, and capital gains income, and elimination of the SS/Medicare tax in favor of private accounts and insurance with top-offs for the poor funded from general revenues. All of which is far from what Bush has prescribed, but even further from Kerry. (This is the "respectible" supply side position - no Laffer curve, no "dynamic scoring", just taking advantage of low marginal tax rates and universal treatment of all income to avoid unnecessary economic distortions and inefficiencies.)

Lawrance George Lux writes:

The cyclically-adjusted deficit was entirely wrong, if you dismiss Keynesian stimulus as I do. A balanced Budget remains the best form of economic stimulus. The next best form of economic stimulus is to shift the tax burden upwards, off of Consumers and Labor, and unto business interests. I opine that every 0.1% of Government surplus will occasion 2.1% increase in Consumption, while every 0.1% increase in the deficit leads to a 0.9% decrease in Consumption during which Resource pricing will increase by 0.3%. lgl

Mcwop writes:

William G. Gale and Peter R. Orszag ignore some very important "stuff" in their article.

1. The substantial decline in incomes from 2000 (total AGI earned by all taxpayers in each income bracket declined from $6,423,977 in 2000 to 6,113,778 in 2002). The brunt of that income loss was from taxpayers subject to the highest tax rates. At the same time government spending conitnued to increase. Even without the tax cuts this scenario will cause deficits, and is probably a significant contributor.

Boonton_98 writes:

Bush as a macro-econ student would get a C-. Tax cuts are stimulative in a recession as are spending increases but over the long run a deteriorating budget is a drag on an economy's long term growth. In other words, going into debt to get out of a recession has a cost over the long run. Hence it is sensible to make sure get the most out of every dollar of 'stimulus' you decide to do.

Bush's cuts fail horribly here. They were not centered on the lower and middle class, many were phased in over long periods of time and some are simply too complicated to have an immediate impact on consumption (see the dividend tax cut and estate tax elimination). Even worse, the tax cuts seem designed to prevent the gov't from building up any sort of surpluses in peak times in order to minimize the borrowing that will be necessary as the population ages.

On the spending side what more needs to be said? Bush's policies make sense if you assume the world is coming to an end in 5-10 years but not if you're planning on being alive beyond that.

DMD writes:

Tax rates have very low correlation with tax revenues. Economic growth, however, does have a high correlation with tax revenues. By cutting tax rates in the 1980's, the economy was able to expand and grow with the result being a doubling of the tax revenues in that decade. The debt, during that time, is attributable not to decreased revenues, but rather to spending increases in excess of the revenue increases.

During the 1990's, the capital gains tax rates were cut dramatically which unlocked previously dead capital (grand ma finally willing to sell her ATT shares with a cost basis of $1.) This stimulated quite an economic boom which caused tax revenues to increase so rapidly it caught politicians off guard and a surplus accidentally occurred ("oops, we could have spent more" was their lament during the surplus years).

Bush's tax cuts, as in previous tax rate reductions, are meant to spur the economy and ultimately increase tax revenues. Without the tax rate reductions, the economy and tax revenues would have been much worse than they are now. We will never know how bad the economy would have been had the tax cuts not been enacted.

As far as the federal deficit is concerned, we are not truly concerned about it so long as we keep talking about tax rates when the real culprit is the growth of government in excess of the growth of GDP.

Boonton writes:

Can't play it both ways DMD. You claim that tax revenue is associated with economic growth but not actual tax rates. Then you try to claim Bush's cutting tax rates prevented lower economic growth than we actually saw in the last few years.

If tax rates cause economic growth (or vice versa) then tax revenue would be correlated to tax rates...only in the opposite direction. Unfortunately there is no 'tax rate' that we can study. At any given point in time there are a host of tax rates as well as different ways of earning money that may or may not be taxed at those rates so studying the relationship is not very easy at all.

Boonton writes:
During the 1990's, the capital gains tax rates were cut dramatically which unlocked previously dead capital (grand ma finally willing to sell her ATT shares with a cost basis of $1.)

This sounds good but is meaningless. Selling shares does nothing in itself to increase or decrease real capital in the economy.

Bob writes:

Nice point Boonton - people too often think of the secondary markets as allocating capital. But you don't believe that cutting the rate at which capital is taxed has no impact on the amount and distribution of real capital in the economy, do you? Also, I think that DMD's point was that the cut stimulated tax revenues, not real growth. Tax revenues go up sharply in the short-term but capital investment probably only goes up modestly because the tax rate on capital can always be raised in the future.

Boonton writes:

Well let's look at the Grandma who has a lot of AT&T shares with a cost basis of $1. Because she has a lot of paper profits, she is reluctant to cash in and be taxed. On the other hand, her paper profits are quite risky. Say AT&T is at $101 a share and her tax rate is 30%. If she sells a share today she profits by $100 which leaves a net profit of $70. However, she is also aware that if AT&T falls to $60 tomorrow she will have only $41.30. So waiting for capital gains tax rates to fall has a cost in terms of risk.

But what about real capital? Imagine AT&T's only real capital is a large network of Internet lines. Does anything happen either to this physical capital or its management when grandma sells her shares? No. Is there any clear direct incentive that would cause AT&T to increase its capital? Say by building wireless Internet towers? No. In fact, selling AT&T shares might cause a drop in price which might discourage AT&T from raising money to make such an addition to the capital stock.

I don't see any meaning behind the phrase 'dead capital' except that maybe a reluctance to sell her shares may make it more difficult for someone to take over AT&T. If AT&T was mismanaged then perhaps making a hostile takeover easier would improve the use of AT&T's capital. But there's a large disconnect between shareowners and management of a most cases.

To go after 'dead capital' just one more time. Grandma selling her shares of AT&T and, say, buying Intel doesn't effect the real economy in any obvious manner. AT&T loses none of its capital and Intel gains no new capital from the transaction. It's not even clear the transaction will increase the trade happening on the stock market. In order for grandma to sell her shares, someone else must buy and for her to buy Intel shares an Intel owner must sell. You're rearranging who owns AT&T's lines and Intel's chip factories but you're increasing neither the lines or the factories.

Robert Schwartz writes:
For Discussion. Was the cyclically-adjusted deficit during the first Bush term too large, too small, or about right?
Now that my last post is up in the left hand column, I am paralyzed. I will never be that good again.

I think there are 2 possible answers. One is that the markets have given us the answer to this question in the form of prices. Unfortunately, the markets are gnomic and mix the anwsers to this question in with the answers to lots of other questions also, and we have no way of sorting out the answers we want from the ones we don't.

The other possible answer is that we should wait until the data is collected for a reasonable period of time, say five years, which will probably take about seven years after the event, and then we can analyze it using the conventional analytic tools.

My son who is in the 11th grade is interested in studying economics. This maybe a good disertation topic for him.

"One word more about giving instruction as to what the world ought to be. Philosophy in any case always comes on the scene too late to give it. As the thought of the world, it appears only when actuality is already there cut and dried after its process of formation has been completed.... When philosophy paints its grey in grey, then has a shape of life grown old. By philosophy’s grey in grey it cannot be rejuvenated but only understood. The owl of Minerva spreads its wings only with the falling of the dusk." Georg Wilhelm Friedrich Hegel (1770–1831)
Lawrance George Lux writes:

I must be the only one who thinks the shift of the tax burden upward with the 1993 Tax Code brought on the boom of the 90s. Boonton's Capital Gains tax reductions came at the apigee of the boom conditions.

Another point: The correlation of Tax revenues to tax rates is a Bell curve. There is a point where reducing tax rates will reduce tax revenues. That point was arrived at with the first of the younger Bush's tax rate cuts. Do not expect that increased economic activity will ever return tax revenues to the position held previous to the administration's tax cuts. lgl

Bernard Yomtov writes:

I don't think your question is fair, Arnold. The criticism of Bush's tax cuts is that they were the wrong kind. As rvman says, and you surely understand, the Keynesian approach would call for temporary tax cuts aimed at those who are most likely to spend the extra money. Bush's tax cuts were the exact opposite.

You may disagree with that particular anti-recession strategy, but you cannot really claim it's the one Bush tried.

p writes:

WOW!!! Great question Kling! The question demonstrates the bias many hold against Bush.

If done left handed, tax cuts work; but if done by the right hand, they don't. I guess its all in the angle.

Seriously, I think that the short vs long argument is foolishness given dynamic modeling. What is interesting and worthy of discussion is how much worse we would have been if the cuts were not taken.

Bob writes:


Waiting for capital gains tax rates to fall has a cost in terms of risk? What are you assuming Grandma is doing with the money from the sale? I thought we were all going on the implicit assumption that it would be reinvested in equity (say, Intel). No risk unless Grandma is poorly diversified because AT&T has done so well.

You are missing the point of how secondary markets impact the distribution of real capital - which is exactly that AT&T shares are NOT going down because Grandma isn't selling. This provides a false signal of investors view of AT&T's investment opportunities and *too many* fiber optic lines and wireless internet towers (and cable acquisitions, etc.) are financed. The opportunity cost is whatever is not funded. How big this cost of "bad market prices" ends up being - and how much capital gains taxation contributes to bad prices - is impossible to measure but the hundreds of billions overinvested during the internet boom suggests that it should not be dismissed.

Boonton writes:

So on one hand the cut in the capital gains taxed caused the Internet boom, on the other hand hundreds of billions of dollars were incorrectly invested in the boom because of the supposed distortion caused by capital gains taxes? Never mind that those who benefitted the most from the boom were not old companies that Grandma might have had shares in from 1950 but new companies like, Microsoft, even Intel. Who had the money to invest in these new stocks if the tax code locked all the cash into IBM and Coca-Cola?

Boonton writes:

To give a more rigerous response, though; AT&T is unlikely to suffer from overinvestment due to capital gains taxes for several reasons:

1. A huge amount of money is only indirectly effected by capital gains concerns. Mutual funds, for example, can buy and sell as they please leaving their owners to pick up the tax bill. Granted some funds are tax managed to take into account the owners' capital gains liabilities but many are not.

2. Another huge amount of money has no connection to capital gains taxes. 401K's, pension funds and other similar accounts for example are exempt from capital gains taxation. For 401K's, only the final income withdrawn from the account in retirement is subject to taxation.

3. Since capital losses are allowed to (partially) offset capital gains, every time someone looses money in the market an opportunity is created to offload a profitable stock tax free.

So if AT&T was overvalued because Grandma was reluctant to sell her shares for fear of the capital gains taxman there would still be hundreds of billions of dollars that could move in and either sell AT&T from their own holdings or even sell AT&T short. If Grandma rationally believes AT&T is 'past its prime' she would be quite irrational to hold it simply because of the capital gains tax.

Bob writes:

There is no reason to believe that capital gains tax cuts "caused" the internet boom (did I say that?). There is no reason to believe that dead capital, to use your favorite term, caused distorted investment during the boom. The point is that bad prices from the boom caused distorted investment and the cost was high ($500m of risk capital consumed - wasted - by online pet supply stores is only a minor example). To the extent that capital gains taxation increases bad pricing, it distorts investment in costly ways. Your case that it does not is not convincing. The empirical evidence (e.g., additions to the S&P500 index) on the supply curve for stocks goes the other way. We could debate how important this effect is - and whether the efficiency costs of capital gains taxation is bigger or smaller than the costs of other types of taxation - but it is not zero.

Boonton writes:

Wait a second, how could 'dead capital' be associated in any way with the Internet boom. If 'dead capital' locks up money in old companies then by definition it would inhibit a boom that consisted mainly of a lot of money going to unknown companies. If your theory was correct, the 'boom' would be happening in old companies who look deceptively strong when you look at their charts because grandma's were 'locked in' by the capital gains tax.

Ann writes:

Boonton -

I'm surprised that no one has pointed out the limits to your comment on secondary markets. Secondary market trading doesn't directly provide funds to companies, but to assume that they don't affect a company's cost of funding, one has to assume that, when people buy stock, they're not thinking about the future. If that's true, why would they buy stock?

People value liquidity, and they value their expected after-tax returns. More secondary market liquidity (from more people willing to trade) makes people more willing to invest, and thus more willing also to buy primary stock issues, thus lowering the funding costs of corporations. People who expect to be able to keep a higher proportion of their gains are willing to accept lower (before tax) expected gains, which makes them willing to pay higher amounts for primary equity issues, which lowers the cost of funding for corporations.

Boonton writes:


Let me go thru my thinking on this matter. A stock price should reflect the expected future income streams of a corporation discounted down to a present value. What happens if a stock is overvalued? What should happen is that players in the market will sell the overvalued stock (whether or not they own it) and buy other stocks (which would be undervalued).

Can this process be stopped or slowed down significantly if some players in the market are unable to do this? I'm going to say no at least as far as capital gains taxes are concerned. There are simply too many players with too much money who are in a situation where they do not have to worry about capital gains taxes.

This may sound strange to you but it is no different than any other inhibition that operates in a market. There are some houses that may be undervalued but there are people that cannot buy them because they do not have the money or cannot borrow enough. Does this mean the houses are 'stuck' at being undervalued? No because there are enough players with the resources to step in and correct the imbalance.

Unlike real estate, financial assets like stocks and bonds exist in an already liquid market. If this is the case then there it is very unlikely that IPO's or bond issues are failing to raise sufficient funds because of poor liquidity. Extra liquidity doesn't hurt but at some point it is like adding water to soup that is already nearly all water.

You assert that investors would be willing to pay more for an IPO *but* why? If an IPO has a present value of $500B that is how much they should pay regardless of how many other people are able to play in the market. The only way this might change is if investors are willing to accept a lower discount rate. A lower discount rate would mean present value would rise towards future value thereby lowering the cost of capital to everyone.

But now you are playing with a double edged sword. You are asking for what is, in essence, a cut in long term interest rates. Simply increasing the potential reward for saving (thru a cap. gains tax cut), though, has an unclear effect on savings. On the one hand, better after-tax returns encourage more savings. On the other hand, better returns means a *lower* amount of saving will 'work harder'. If your goal is to have $1M by 65 then you can save *less* per year if gov't taxes your returns less.

A better policy, IMO, would be for the gov't to show it is serious about controlling the long term deficit. This would lower long term interest rates to the benefit of all seeking long term investment funds.

Ann writes:

If I thought that the alternative to tax cuts was a lower deficit (as opposed to more spending regardless of whether it was needed, which is what we got in the last budget under Clinton simply because the money was there), and if I was convinced that high vs. low capital gains rates would lead to higher revenues, then I'd oppose a cut in the capital gains rate. But, if the question is whether lower capital gains tax rates will lower the cost of funding for corporations, then those points aren't relevant.

As for IPOs, you make an extremely strong assumption - if everyone knows that an IPO is worth $500 billion, then why wouldn't they pay that? The problem is, where does this knowledge come from? The whole justification for IPO auctions (such as Google's) is that people wake up knowing the true value of this stock that has never traded before, but IPO auctions have worked poorly in practice in pretty much every country that has used them.

In practice, evaluating an IPO, or even a stock that is already trading, takes work. People won't choose to do that work and participate in an offering unless they expect to be rewarded for their time, effort and risk (and this premium is on top of underlying base interest rates, so it doesn't require a shift in long term risk-free rates). They'll calculate this premium based on after-tax returns, and the risk they factor in will depend on future expected liquidity, price accuracy, etc. IPOs work to attract the attention of investors. Investment bankers particularly complain about how hard it is to fill up road shows during times when the market is doing well (it gets easier to get people to show up in slow times, although it's harder to get them to like the stock then). If everyone knew the precise value of a stock, then the issuer could just set the stock at the right price and everyone would buy it for that amount (a method that used to be common around the world, except that the issuer had to set the price at a substantial discount because it didn't know the "true value").

There may be something to your claim that the marginal investor is tax free, and thus prices don't reflect taxes, but I'm not convinced. At the very least, it's hard to tell who the marginal investor would be, and it's hard to imagine returns not being affected at all by genuine costs born by a large portion of investors.

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