Monday, May 21, 2012
Discussion of the so-called fiscal cliff—the combination of tax increases and spending cuts that will come in 2013 if Congress and the president don't act—confuses a number of different issues. The evidence suggests that we should fear the tax hikes, but not necessarily the spending cuts.
Anyone who uses the term "fiscal cliff" accepts a Keynesian view of the economy, knowingly or not. Both tax increases and constrained spending are assumed to be bad for the economy.
But there are two other views: that of the budget balancer and that of the supply-sider. Rather than term the impending changes that will occur in 2013 a "fiscal cliff," the budget balancer thinks of this as "fiscal consolidation." Tax increases reduce the deficit, as do cuts in government spending. Both are austerity measures that make the government more responsible and, therefore, both are conducive to long-run economic growth. Those who support the Simpson-Bowles plan subscribe, at least in part, to this view. ... The budget balancer regards both tax increases and spending cuts as moves in the right direction.
The supply-sider has a different view from both the Keynesian and the budget balancer. Fundamentally, supply-side advocates focus on the harmful effects of tax increases. Raising tax rates hurts the economy directly because tax hikes reduce incentives to invest and because they punish hard work. As such, tax increases slow growth. But budget cuts work in the right direction by making lower tax revenues sustainable. If spending exceeds revenues, then the government must borrow and this commits future governments to raising taxes in order to service the debt. ...
Which of the three views is correct?
On the tax side, there is strong evidence that supports the supply-siders. Christina Romer, President Obama's first chairwoman of the President's Council of Economic Advisers, and David Romer document the strong unfavorable effect of increasing tax rates on economic growth [The Macroeconomic Effects of Tax Changes]. They report that an increase in taxes of 1% of gross domestic product lowers GDP by almost 3%. The evidence on government spending also suggests that high spending means lower growth.
The evidence on government spending also suggests that high spending means lower growth. For example, Swedish economists Andreas Bergh and Magnus Henrekson survey a large literature and conclude that an increase in government size by 10 percentage points of GDP is associated with a half to one percentage point lower annual growth rate [Government Size and Growth: A Survey and Interpretation of the Evidence].
The evidence suggests that we should move away from worry over the impending "fiscal cliff" and focus more heavily on concern about raising taxes. And although some Keynesians may view this as not the best time to control spending growth, promising to change our ways in the future is as credible as Wimpy's promise to pay on Tuesday for the hamburger that he eats today.