Forty Years of Reaganomics

July 18, 2018

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When he was running for president in 1980, Ronald Reagan used to ask his audiences, “Are you better off than you were four years ago?” If they were tired of high gas prices, double-digit inflation, and the Iranian hostage crisis, then voters should choose him over the incumbent, Jimmie Carter.

Reagan’s primary domestic policy aim was to shrink the size of government by cutting taxes, spending, and regulation. If only the government would get out of the way, so the theory went, the private sector could flourish. Although Democrats haven’t always gone along with this agenda, Republicans have had their way often enough to bring about a new era of low taxes and limited government. Even Bill Clinton agreed that the era of Big Government was over. Despite all the talk about how Donald Trump is somehow less Republican or less conservative than his predecessors, his tax, spending and regulatory proposals are right out of the Reagan playbook.

Now that almost forty years have passed since the “Reagan revolution,” we may well ask, “Are we better off than we were forty years ago?” I would like to make a modest contribution to an answer by looking at some of the macroeconomic indicators I have been discussing in recent posts. In order to make it easier to compare statistics across the years, I will express the various indicators as shares of gross national income (GNI) when discussing income, or as shares of gross domestic product (GDP) when discussing expenditures. The difference between GNI and GDP is relatively small and should not create any confusion in this discussion. (See my previous discussion of macroeconomic indicators, especially part 2 and part 3.)

Taxes

National income can go to pay taxes, to consume goods and services, or to save, as expressed in the equation GNI = T + C + S. Tax cuts increase the disposable income available for consumption and saving. Generally, more of that increase goes into consumption than into saving. Since consumption is the largest component of GDP, tax cuts raise what is spent on production. That effect includes a multiplier effect as the increased GDP creates additional income and consumption.

[One technical note: In the national accounting system, the T stands for taxes net of transfer payments, which are payments from the government to its citizens. Payroll deductions for Social Security are taxes and count toward T, but Social Security checks are transfer payments and count against T.  The “tax cuts” discussed here could include some increases in transfer payments, but those too would increase disposable income.]

Before the Reagan election in 1980, taxes had been taking about 17-20% of national income. That includes all kinds of taxes—income, sales, payroll, property—and all payers, personal or corporate. Congress passed substantial tax cuts during the administrations of Ronald Reagan, George W. Bush, Barack Obama and most recently Donald Trump. The national tax rate dropped from about 18% to 16% by the end of the Reagan and Bush administrations (1992); then to 14% by the end of George W. Bush’s first term (2004). Then came the global financial crisis and the Obama stimulus package, which lowered taxes briefly to 10% of national income. Now the rate is 12%, which reflects the economic recovery and some initial effects of the Trump tax cuts.

The rate of consumption has risen accordingly, whether calculated as a percentage of GNI or of GDP. It was running about 60-61% of GDP before 1980, but it is up to 69% now. That is well above the rate of most wealthy countries. It reflects the fact that we have become a relatively low-tax nation, with a high priority on the purchase of private goods and services.

Some of that increased consumption has gone into imported goods. We were running small trade surpluses in the 1960s, but the higher price of oil helped produce trade deficits in the 1970s. In the era of lower taxes since 1980, imports have grown dramatically. The trade deficit as a percentage of GDP peaked before the global financial crisis of 2007, but has settled back to about 3% recently.

The federal tax cuts have also made the tax code less progressive, so that the wealthy have benefited more than the middle class. Lower taxes give business owners and managers more incentive to claim a higher share of profits for themselves, since the government lets them keep more of their gains. The distribution of both pre-tax and after-tax income has become more unequal during these years.

Government spending

Another goal of Reaganomics was to reduce government spending. That meant especially domestic spending, since military spending was to be kept high. That task proved to be more difficult and contentious.

Although cutting taxes and cutting spending may seem to go together in a program to shrink the size of government, they are quite different matters. Spending changes can actually have a bigger effect on GDP than tax changes, and the effect tends to be in the opposite direction. That’s because government spending has a direct positive effect on GDP. It counts as spending on productive economic activity. Then, by affecting income, it has multiplier effects on consumption as well. Spending cuts lower GDP, other things being equal. Tax cuts raise GDP, but only indirectly through the disposable income that goes into domestic spending rather than spending on imports or saving for the future.

Recall the equation: GDP = C + I + G + NX.
(Gross Domestic Product = Consumption + Investment + Government Spending + Net Exports)

Government spending is a component of GDP. But taxes only effect GDP through their indirect effects on consumption and net exports.

That means that if Americans are willing to incur an additional $100 billion in the annual deficit, increasing spending has a lot to be said for it instead of cutting taxes. The overall effect on GDP should be greater, and the mix of public and private benefits may add to the quality of life. Cutting taxes increases spending on private goods, but raising spending provides public goods (that’s what government spends on) and private goods too (through the effect on income and consumption).

In any case, Republicans wanted to shrink government, not expand it, and they had some success in cutting domestic spending. Before 1980, government spending was running at 21-24% of GDP, but now it is down to 17%. (Part of that drop, but only part, is a consequence of using percentages to measure the changes. If one component of GDP increases its percentage share, others must go down, other things being equal. Here C went up and G went down, but neither change was just a mathematical adjustment to the other.) We know from the increased deficit that taxes have been cut more than spending. And since consumption has risen substantially, it’s safe to say that the big tax cuts increased GDP more than the spending cuts lowered it.

Saving and investment

Another goal of Reaganomics was to increase saving and private sector investment. Tax cuts would give people more money to save as well as consume, and strong consumer demand would encourage the investment of those savings in business expansion. Economic growth should remain strong, since the rising investment component of GDP would offset the falling government component.

Some of the consequences of fiscal policy flow from well-established economic principles, such as lower taxes—>higher disposable income—>higher consumption. But higher investment does not automatically follow from lower taxes. It depends on whether businesses find the economic demand sufficient to justify expansion. For example, airlines will meet the demand for more air travel by filling empty seats before they will invest in new planes. Businesses invest more when they anticipate a strong market for their expanded production.

I do not see in the macroeconomic indicators a surge of saving or investment since 1980. Before then, saving was running at about 19-22% of national income, while investment was in the range of 16-18% of GDP. Reaganomics got off to an auspicious start, with saving up to almost 23% and investment up to 20% by the end of Reagan’s first term. But since then, saving and investment have generally been no higher than they were before. Saving is now at 19% of GNI, and investment is at 17%.

I’m not sure why the desired surge of investment did not occur, but here are a few possibilities. Some of the increased consumer demand has gone to support foreign production, which made domestic expansion less necessary. The Federal Reserve has also been very quick to ward off inflation by raising interest rates whenever rising demand started to push up prices. Higher interest rates discourage borrowing for business expansion. And although new technologies have been emerging, how to utilize them productively and profitably in a largely service economy has remained a question.

Sector balances

The economy consists of three sectors, each with its own financial balance resulting from inflows and outflows. They are the government sector, the domestic private sector, and the external (foreign) sector.

Ever since the Roosevelt administration engaged in massive deficit spending to combat the Depression and fight World War II, government has experienced more budget deficits than surpluses. Before 1980, deficits were running about 2-4% of national income. Since 1980, deficits of 4% or more have been common, except during the Clinton presidency, which ended in a small surplus. The deficit rose again in the George W. Bush and Obama presidencies, first because of the Bush tax cuts, and then because of the global financial crisis and the Obama stimulus package. The deficit was 9% of national income in 2012, but is down to 5% now.

As I discussed in my post on sectoral accounting, one sector’s deficit is another sector’s surplus. When the government experiences an income shortfall by spending more than it receives, some other sector must experience an income surplus by receiving more than it spends. Before 1980, that other sector was the domestic private sector. Households and businesses were saving more than they spent either on consumption or investment in real assets, with the difference showing up as financial assets. But since the 1980s, we have had a balance of trade deficit (and a current account deficit, which is the balance of trade adjusted for other financial flows between countries). Now about two-fifths of our government deficit winds up as surplus dollars in the hands of foreigners. By running such a large deficit, government is enabling both Americans and foreigners to accumulate financial assets.

While our government has been enabling the accumulation of private financial assets for some time, it used to do it in a more egalitarian way, through public-sector job creation, wages and the expansion of public goods. Now we do relatively less of that, and more with tax cuts aimed at corporations and the wealthy. That’s another reason why the distribution of income has become more skewed.

Gross domestic product

To summarize the changes in component shares of GDP, the consumption share is up sharply, government spending is down, investment has remained about the same, and net exports have fallen as the trade deficit has worsened. In the era of Reaganomics, we have been relying primarily on tax cuts to grow the economy instead of on public spending, business investment, or global demand for our products.

How much growth has our fiscal policy helped to achieve? I used data on real (inflation-adjusted) GDP to compute the cumulative growth for two different periods, 1945-1980 and 1980-2016 (the last year in that data series). Then I calculated the annual growth rate that would yield, when compounded, the cumulative result.

For 1945-1980, GDP grew 191%, which implies an annual rate of 3.1% compounded.

For 1980-2016, GDP grew 159%, which implies an annual rate of 2.7% compounded.

This confirms what others have reported, that growth in the Reaganomics era has been on average slower than in the previous postwar era.

This slower growth has also come with other costs: some neglect of public goods and services such as infrastructure repairs, a larger national debt, a larger trade deficit, and greater inequality.

With regard to the inequality, Piketty has argued that slower growth itself contributes to it, since workers rely on economic growth for real wage increases. Big investors rely more on the rate of return on capital. As the rate of growth falls farther below the rate of return on capital, the share of income going to capital rather than labor goes up. This is in fact what has been happening, a trend Piketty describes as a “drift toward oligarchy.” I think the drift toward economic oligarchy is related to the current threat to democracy, of which Donald Trump’s authoritarian tendencies are only one manifestation.

Government fiscal policy is by no means entirely to blame for sluggish growth. Factors such as slower population growth, an aging population and the difficult transition from a manufacturing economy to a service economy are also involved. But going forward, we do need to think about what combination of public and private initiatives can help.

We have probably gone about as far as we can go with tax cuts as the way to prop up a struggling economy. And government spending cuts without tax cuts would almost certainly be worse. The question for economists and policymakers today is how to make the best use of government spending to give the economy what it really needs. Among the things it needs are enhancements to human capital to keep up with changing job requirements, development of cleaner energy sources, and a twenty-first-century infrastructure. And as Modern Monetary Theory advocates, creating public jobs for anyone who wants them is one of the most direct ways of boosting national output and income.

The anti-government philosophy that has dominated the Reaganomics era has outlived its usefulness. I think that Republicans will either have to change their tune, or tone down the anti-government chorus so that new music can be heard. Democrats need to convince voters that their proposals serve the common good and not just the needs of particular constituencies. Warrenomics anyone?

 

 


MMT 7: A Full Employment Proposal

July 11, 2018

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This is the seventh in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

The goal of full employment

The authors argue for full employment on both economic and ethical grounds. Enabling everyone who wants a job to get one maximizes national economic output, providing more goods and services to distribute. Failing to do so not only hurts unemployed individuals and their families, but does lasting damage to economy and society in general:

Persistently high unemployment not only undermines the current welfare of those affected and slows down the growth rate in the economy below its potential, but also reduces the medium- to longer-term capacity of the economy. The erosion of skills and lack of investment in new capacity means that future productivity growth is likely to be lower than if the economy was maintained at higher rates of activity.

The authors are very critical of the dominant trend in recent economic policy, which is to tolerate unemployment while giving priority to fighting inflation. Policymakers came to accept unemployment rates far above the 2% or lower that was normal in the mid-twentieth century. High unemployment has also been accompanied by underemployment, as many workers have been unable to work as many hours as they would like, and also labor force withdrawals, especially by men. The official unemployment rate does not tell the whole story.

The inflation-fighting part has worked pretty well. Sluggish economic growth and high unemployment weaken the bargaining position of labor and help keep wages down. In turn, low labor costs and weak consumer demand keep firms from raising prices. In general, “the use of unemployment as a tool to suppress price pressures has, based on the OECD experience since the 1990s, been successful.”

The authors are troubled by the injustice of making a minority of the population bear the costs of a weak economy. “Joblessness is usually concentrated among groups that suffer other disadvantages: racial and ethnic minorities, immigrants, younger and older individuals, women (especially female heads of households with children), people with disabilities, and those with lower educational attainment.” I would add that the injustice is compounded if those who do make income gains in this economy are mainly the wealthiest 1%. The benefits of price and currency stability are somewhat more widely shared, but “it is doubtful that a case can be made for their status as a human right on par with the right to work.”

The Job Guaranty

Not all countries experienced high unemployment after the end of the postwar economic boom. Some, such as Norway, did more to insure that everyone who wanted to work could find a job.

The idea of the Job Guaranty is fundamentally simple. Since full employment is such a social and economic good, the public sector should take up the slack by employing those who cannot find jobs in the private sector.

“Private firms only hire the quantity of labour needed to produce the level of output that is expected to be sold at a profitable price. Government can take a broader view to include promotion of the public interest, including the right to work.”

The Job Guaranty is also known as the “employment buffer stock approach.” A stock of public jobs provides a buffer to protect the economy from a weak private sector.  Government acts to stabilize employment, spending to hire more labor when the private sector is weak, and reducing spending and public employment when it is strong. That would also have a stabilizing effect on national income and consumption.

The authors suggest that the wages paid in the Job Guaranty program would function like a national minimum wage, since they should be low enough to “avoid disturbing the private sector wage structure when the JG is introduced.” It wouldn’t compete with the private sector enough to drive up wages in general. On the other hand, they also want the wages to express “the aspiration of the society in terms of the lowest acceptable standard of living.” They do not discuss how these goals might be in conflict, but advocates of a “living wage” generally regard today’s minimum wage as too low.

Price stability

Proponents of the Job Guaranty expect it to be less inflationary than traditional Keynesian policies, which recommend government spending in general to stimulate the economy. When government increases its general spending, that runs the risk of driving prices up by competing with private firms for labor and other resources. However:

There can be no inflationary pressures arising directly from a policy where the government offers a fixed wage to any labour that is unwanted by other employers. The JG involves the government buying labor off the bottom, in the sense that employment at the minimum wage does not impose pressure on the market-sector wage structure.

Government would not be involved in a bidding war with private companies for labor, since it would only be hiring labor for which there was no other demand.

The benefits would ramify throughout the economy because of the growth in public works, income, and consumer demand. That should stimulate some expansion in the private sector as well, to meet the increased demand. Private firms could get the additional workers they needed by hiring them away from the Job Guaranty program. That would be fine with the government, which would no longer need to employ them. The program simply absorbs unneeded labor until it is needed again, but does nothing to bid up the price of labor. It supplies a boost to aggregate demand only when there is enough unused capacity in the economy to respond to it. So there is no reason to expect either cost-push or demand-pull inflation as a result of the JG itself.

Effects on public deficit and private surplus

The expected economic effects of a Job Guaranty follow from the macroeconomic relationships described earlier.

GNP = C + I + G + CAB  [see MMT 3]

Gross National Product = Consumption + Investment + Government Spending + Current Account Balance

(T – G) + (S – I) + (-CAB) = 0  [see MMT 4]

These three sector financial balances add to zero:

T – G = Government balance of tax revenue minus spending

S – I = Private sector balance of saving minus investment

-CAB = External sector balance expressed as the current account surplus held by trading partners

Let’s start from the present U.S. situation, where financial surpluses in the private sector and the external sector are balanced by a large government deficit.

Let’s hold the external balance constant, so we can concentrate on the effects of a Job Guaranty on the domestic sectors, public and private.

When the Job Guaranty program starts:

  • G rises
  • GNP rises even more than G, because of the consumption multiplier
  • Government deficit rises
  • Private sector surplus rises

We are assuming that the increase in G is not offset by an increase in taxes. That would keep the increase from showing up in disposable income and block the multiplier effect on consumption. Since G rises but T doesn’t, the deficit (T – G) rises.

According to Modern Monetary Theory, the sovereign government can issue currency to spend beyond its revenue, and this public debt is sustainable. The government can also borrow money by issuing more treasury bonds without “crowding out” private borrowing, as is often alleged. That’s because the private surplus must increase in tandem with the public debt in order for the sector balances to offset. The mechanism by which this happens is the effect of Government spending on Saving due to the saving multiplier. Some of each additional dollar of income is saved, so S rises, and the surplus S – I must rise as much as the deficit T – G, other things being equal.

At the end of MMT 4, I expressed some concern that surplus savings not invested in real productive assets could lead to excess speculation and financial instability. This text does not address that possibility, but it makes me nervous about growing public deficits and private surpluses indefinitely.

Hopefully, the Job Guaranty program stimulates the general economy. As aggregate demand rises, the private sector needs to hire away more of the labor in the Job Guaranty program, so the program can be scaled back. But in order to sustain GNP at a high level, another variable in the GNP equation must increase to offset any reduction in government spending. Presumably that would be Investment, since the firms hiring more labor will also be providing more workplaces, equipment and expanded inventories. That leads to this optimistic scenario:

As private sector demand picks up:

  • G falls, but I rises
  • GNP is sustained at full-employment level
  • Government deficit falls
  • Private surplus falls

Private surplus (S – I) falls because of the rise in investment, which absorbs more of the uninvested saving. I also think that when the private sector is strong, it might be a good time to reduce the public deficit and private surplus by raising taxes on the wealthy, but the text does not get into that.

Necessary but not sufficient?

I like the text’s proposal for a Job Guaranty. I accept the authors’ argument that increasing public debt to fund it is not necessarily bad, since public debt is more sustainable than private debt. I would hope, though, that a period of expansionary fiscal policy might get the economy to a place where public deficits and other sector imbalances could actually be reduced.

One potential problem with the optimistic scenario is that investment in new technologies might displace too much labor, throwing millions of workers back into the Job Guaranty program. As private sector demand picks up and the private labor force moves toward full employment, that would strengthen the bargaining power of labor, according to the author’s conflict theory (see MMT 6). Ideally, investment in new technologies would raise worker productivity and justify wage increases. That would be a long overdue boost in productivity, which has been rather stagnant lately. On the other hand, automated and artificially intelligent systems could replace too many workers, especially those with limited education and technical skills. One can imagine a large underclass of otherwise unemployable workers stuck in minimum-wage jobs in the Job Guaranty program.

In order to develop human potential to the fullest, which is one of the text’s goals, government may need to spend on human capital development as well as the Job Guaranty, although the same program would have some effect on both. General spending to promote education, training, health care, and so forth are also needed.

Writers such as Martin Ford in The Rise of the Robots envision a massive welfare system to support people whose labor is no longer needed. I agree with the authors of Modern Monetary Theory and Practice that paying people not to work is a tremendous waste of human resources. “Providing welfare rather than work to those who want to work is not only an admission of defeat (the labour market fails to provide enough jobs), but also wastes resources and generates social costs.”

I accept the fundamental premise of this economics that “the most important resource in any economy is labour.” I want to enable people to do marketable work of some kind, although new technologies could raise productivity to the point where they wouldn’t need to devote many hours to it. I think that goal is best achieved through a balance of public and private investment. I hardly need to point out that little of this is likely until the present regime is history.


MMT 2: GDP and Government Spending

July 3, 2018

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This is the second in a series of posts about MMT, Modern Monetary Theory.

I will now proceed to describe some of the fundamental principles of Modern Monetary Theory, as explained in the text by Mitchell, Wray and Watts. These may seem a little dry and abstract at first, but how they apply to real-world issues should become apparent very quickly.

GDP and its components

Since macroeconomics is interested in aggregate outcomes, especially the goal of using the available labor and other resources to the limit, its central concept is Gross Domestic Product. “GDP is the measure of all currently produced final goods and services evaluated at market prices.” It represents a country’s entire domestic output.

Economists measure GDP in several different ways, the easiest of which is to add up the various kinds of expenditures on goods and services. These fall into several categories:

  • Consumption (69%): spending on new goods and services by households. That does not include personal financial investments, which are considered savings and not goods or services; and it does not include new home purchases, which are part of Investment below.
  • Investment (17%): spending on plants, equipment and new inventory by firms, and real estate investment by households. It includes only real assets, not financial assets like stocks and bonds.
  • Government spending (17%): spending by all levels of government, including investments in long-term real assets like highways. It does not include transfer payments like Social Security checks or food stamps, which are counted in Consumption when they are spent.
  • Net exports (-3%): spending on exports minus spending on imports. Foreign spending on the products we export contributes to our domestic output, while spending on products we import contributes to foreign output. It is negative because our imports exceed our exports.

The percentages indicate the current contribution of each component to U.S. GDP. The first three add up to 103% because the last subtracts 3%.

This is summarized in the formula  GDP = C + I + G + NX

Domestic output and domestic income are two sides of the same coin, since every expenditure by one economic unit is income for another. “The basic macroeconomic rule then is that, subject to the existing productive capacity, total spending drives output and national income, which, in turn, drives employment.”

Modern monetary theory looks at the economy primarily from the demand side. It assumes that supply is usually pretty responsive to demand. If the government wants to order more airplanes, Boeing will be happy to fill the order. Increases in demand can boost GDP as long as the economy is not already running at full capacity, which it rarely is.

Government spending and GDP

Government spending accounts for 17% of U.S. GDP, not nearly as much as consumption but just as much as business investment and new home buying.

The potential benefits of government spending are twofold: first, it creates public goods and services like highways and public education; and second, it provides employment and profits for private sector enterprises, such as construction companies that build the roads and schools.

Although reducing the size of government is a popular conservative goal, cuts in government spending can be expected to reduce GDP because they are not offset by increases in other components of GDP. Reductions in highway construction are unlikely to be offset by increases in automobile purchases. Quite the contrary, since the spending cuts represent lost income to someone, and lower incomes reduce consumption, which is the biggest part of GDP. Spending increases, on the other hand, can increase GDP both directly and indirectly through their positive effects on income and consumption.

Multiplier effects

The indirect effects of spending changes on GDP are called “multiplier effects,” and they have a precise mathematical description.

Let’s say that for every additional dollar of disposable (after-tax) income, people devote 80 cents to consumption. The technical term for that .80 is the “marginal propensity to consume,” designated by c. Some people consume a larger proportion of their income than others (especially if they don’t have very much), but as usual we are interested in aggregating and using an average.

Thus if $1 was injected into the economy, through additional spending, total income would initially rise by $1. If the marginal propensity to consume was 0.8, then this initial rise in income would induce a rise in consumption of 0.8 x $1 or 80 cents in period 1. This initial $0.80 rise in induced spending would further induce a rise in income of $0.80 which would induce additional consumption in period 2 of 0.8 x 0.8 or 64 cents and so on.

The sequence of 1 + .8 + .64 + .512 is called a “power series” in mathematics because each number is a power of c. The sum of all the numbers comes out 1/(1-c), which in this case is 1/(1-.8) = 1/.2 = 5. In theory, a $1 increase in spending could result in a $5 increase in GDP. In practice, there are other variables that complicate things a bit. But in essence, this is the basis for expecting government spending to stimulate and grow the economy. We are asserting that real output has room to grow, that growth in output generates growth in income, and that consumer demand then drives further growth in output and income, in a virtuous circle.

Does that sound too good to be true? If you want to know where that first $1 came from, or whether there’s a catch somewhere, you are asking the right questions. But if you are sure that you can’t grow an economy by increasing spending, the modern monetary theorists have something to tell you.

What’s the limit, tax revenue?

Let’s play devil’s advocate. If growing the economy were so simple, why not let government spending go sky high? The obvious answer is that like a household, the government shouldn’t spend more than its revenue. That’s the wrong answer, as far as MMT is concerned, but let’s go with it for a moment.

If government has to raise taxes to pay for any spending increases, that wipes out the multiplier effect. That’s because the calculation of increases in consumer spending are based on disposable income, after taxes have been removed. If the government increases spending by $1 billion, but raises taxes by the same amount, gross income goes up $1 billion but disposable income doesn’t go up at all. (Of course it goes up for those who got jobs as a result of the spending, but in the aggregate that’s offset by the tax increase.) The increase in spending will expand the public sector and employ some people there, but there won’t be any further expansion in the economy as a whole.

Still, even that is something. G is part of GDP, so if the government can make good use of otherwise underutilized resources, that in itself adds to GDP. If the private sector is under-investing and under-employing, why shouldn’t the public sector take up the slack, especially if it can give people public goods and services that are otherwise lacking?

Suppose you live in a development with some common amenities and a homeowner’s association. The association raises everyone’s dues in order to hire an additional work crew to spruce up the common areas. That adds a service to aggregate output and new income to aggregate income. Your income remains the same, but part of it is allocated to supporting a common good instead of a private good. Aggregate disposable income is unchanged, because the new “tax” reduced yours, but the wages of the work crew increased theirs. The lesson is that reallocating income and labor to a sphere where it can be more fully employed can add wealth. Substitute government for the homeowner’s association, and you have a case for government spending.

Spending beyond revenue

The case for public spending goes beyond the previous example, into the realm of deficit spending. MMT questions the basic assumption that a sovereign government is like a household in needing to limit its spending to its revenue. That’s where aggregate thinking becomes crucial. Assuming that what is true at the individual level is also true at the aggregate level is known as the “fallacy of composition.”

At the individual or household level, living within one’s means is a cardinal principle of financial planning. If you spend less than you make, you can save and invest the surplus. The money you make adds to your income, setting up a virtuous circle that leads to higher net worth and financial security. Spend more than you make and you run up debt. That debt burden on your future income can then send you into a downward spiral of lower net worth and even insolvency.

MMT maintains that a sovereign state that issues its own currency never has to run out of money, although it does have to manage the currency so that it retains its value. Currencies such as the dollar are “fiat currencies,” no longer backed by any finite commodity, such as gold. The dollar’s value depends on the promise of the federal government to accept dollars in payment of taxes, and on the demand for dollars on world markets.

When the federal government spends, it injects money into the economy; when it taxes, it removes money. There is no economic law that prevents the government from injecting more money than it removes, and in modern times that’s what it usually does. The deficit spending boosts the economy by allowing the multiplier effect to work. And as we’ll see later, the excess money spent ends up as a financial asset in the private sector.

Governments without the power to create their own currency, such as state and local governments, or the homeowner’s association thought of as a kind of government, are much more limited in their capacity to stimulate their economies. They have to operate more like households, spending only what they’ve already received in revenue or cautious borrowing.

The real limit–productive capacity

The real limit on spending is not tax revenue, but the productive capacity of the economy. That is limited by the available resources and technologies. It does expand, but not as fast as we would like. Sometimes shortages of specific resources contract it, as in the case of the OPEC oil embargo of 1973.

If aggregate demand increases so rapidly that it starts to strain productive capacity, then the sustained price increases known as inflation can occur.

Once the capital stock is in place, firms will respond to increases in spending for the goods and services they supply by increasing output up to the productive limits of their capital and the available labour and other inputs. Beyond full capacity, they can only increase prices when increased spending occurs.

So when the government wants to build a highway, it may have to bid more for the job because construction companies already have as many jobs as they can handle. Or when it wants to staff a new department, it may have to hire workers away from other jobs by offering higher wages.

Deficit spending when the economy is at or near capacity may end up boosting prices more than GDP. Even if the spending produces a short-term increase in aggregate disposable income (because it wasn’t offset by tax increases), the increased consumer demand will push up prices rather than real private-sector output. A price increase is not the same thing as a multiplier effect on output and real income.

While acknowledging this limit to effective government spending, MMT theorists are far more interested in what can be done when the economy is operating below capacity. They believe that it is usually possible for the sovereign government to stimulate the economy, create employment, and increase domestic output and real income, while at the same time using monetary policy to control inflation and protect the dollar’s purchasing power. They do not believe that inflation fears justify tight monetary and fiscal policies that keep the economy and its workers from achieving their real potential.

Continued


Trump Tax Cuts–Dangerous for the Deficit

October 6, 2017

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Here I mention one other problem with the Trump tax proposal, besides its potential to increase economic inequality by favoring the wealthy. The Tax Policy Center estimates that it would “reduce federal revenues by $2.4 trillion over the first ten years and $3.2 trillion over the subsequent decade.” Without offsetting cuts in federal spending, it could add hundreds of billions to annual deficits and trillions to the national debt.

The question of how tax cuts influence deficits and the debt is complicated by their uncertain effects on economic growth. If the rate of growth goes up, incomes should rise, and taxes on those incomes should bring in additional revenue. Back in 1974, University of Chicago economist Arthur Laffer proposed that a tax cut can actually pay for itself by stimulating growth, while a tax increase can actually reduce revenue by inhibiting growth. This has become a popular argument for tax cuts, despite the weakness of the evidence supporting it. The big tax cuts under Ronald Reagan and George W. Bush did not pay for themselves, but contributed instead to soaring budget deficits.

Tax analysts have two different ways of evaluating the impact of tax changes on revenue. Conventional scoring makes no assumptions about the effects of the changes on economic growth. Dynamic scoring tries to incorporate an estimate of those effects (known as “macroeconomic feedback effects”) into the prediction model.  The Tax Policy Center said this in their first evaluation of the Trump plan:

This report uses conventional scoring methods that assume the tax proposals do not affect the overall level of economic activity. TPC will release supplemental estimates that include macroeconomic feedback effects soon. Based on TPC and the Penn Wharton Budget Model’s analyses of the macroeconomic effects of the House Republican leadership tax blueprint of 2016 (which shares many characteristics with the [Trump] unified framework), we would expect the framework to have little macroeconomic feedback effect on revenue over the first decade.

Translation: Revenue losses might be a little offset by economic growth effects eventually, but don’t hold your breath.

The Trump economic team has been vigorously promoting the idea that the tax cuts will pay for themselves. They seem to be reading from a familiar Republican playbook: Dismiss concerns about the deficit when calling for tax cuts. Then when the deficit goes up, blame federal spending rather than tax policy. Issue dire warnings about bankrupting future generations and call for cuts in programs that primarily help the middle class and the poor. According to the Republican Party line, the country can always afford another tax cut aimed mainly at the wealthy. What it can’t afford is programs like Medicaid or Obamacare to help people pay for health care.

That the current administration would play the same game is disappointing, considering how much Donald Trump has marketed himself as a champion of the working class. His positions on immigration, foreign trade and race do appeal especially to less educated voters. But on fiscal policy, his thinking seems very much in line with the Republican establishment, favoring tax cuts for the wealthy and spending cuts for the poor. He is very good at hiding his real aims behind a populist, pro-worker, pro-growth rhetoric. So far, most of his supporters are sticking with him, even as he sticks it to them with his economic policies.


Can Trump Boost Middle-Class Incomes?

December 2, 2016

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The state of the economy loomed large in the minds of voters as they went to the polls. According to CNN exit polling, 62% of the voters characterized the economy as “not good” or “poor,” and a majority of those who felt that way voted for Donald Trump. The 27% of voters who said they were worse off than four years ago voted for him by a 77% to 19% margin.

Although the economy has been growing steadily since the financial crisis of 2007-08, the rate of growth has been fairly slow, and the income gains from that growth have gone mostly to the very wealthy.

What does President-Elect Trump propose to do for the middle class? He would give them a modest tax cut, create good jobs by spending on infrastructure and negotiating more favorable trade deals, and stimulate the economy to increase the rate of economic growth. (I won’t discuss new trade deals here, since they are such an unknown at this time, and they require the cooperation of our trading partners.)

Taxes and spending

As I described in more detail in an earlier post, Trump would like to reduce personal income taxes and corporate taxes, as well as completely eliminate estate taxes. The income tax cut would provide a small benefit for the middle class. For example, a married couple with a $50,000 taxable income would have their taxes reduced from $6,572 to $6,000.

This might not be a free lunch, however. Like Ronald Reagan and George W. Bush before him, Trump would like to cut taxes and increase military spending at the same time. If past experience is any guide, that would increase the deficit and make it hard to fund any job-creating domestic initiatives. If Congressional Republicans run true to form, they will rush to cut taxes and then clamor for spending cuts to avoid raising the debt ceiling. Trump’s fiscal problem is likely to be especially acute, since he wants infrastructure spending as well as military spending increases. He also wants particularly drastic tax cuts, including complete elimination of estate taxes (a huge financial windfall for his own family and those of his billionaire friends) and a reduction in corporate rates from 35% to 15%.

Trump’s nominee for Treasury Secretary, former Goldman Sachs executive and hedge fund manager Steven Mnuchin, has created some uncertainty about tax cuts for the wealthy. He has said, “Any reductions we have in upper-income taxes will be offset by less deductions so that there will be no absolute tax cut for the upper class.” That would be good news for the rest of us, since it would make the tax cuts fairer and also preserve revenue that could be better spent on job creation. However, Mnuchin’s promise goes against strong Republican inclinations, as well as being in opposition to the plan previously announced by Trump himself. According to the New York Times:

In that plan, middle-class families would see a 0.8 percent increase in their after-tax income, according to an analysis by the Tax Foundation, while the top 1 percent of taxpayers would see a 10.2 to 16 percent gain. Another group, the Tax Policy Center, calculated middle-class families would get a 1.8 percent boost in after-tax income, while the top 0.1 percent of earners would see a 14 percent gain and a tax cut worth an average of $1.1 million.

I will be surprised of Congress can agree on enough changes in tax deductions to offset the large reductions in tax rates that Trump has proposed for the wealthy.

Economic growth

Ever since the Reagan Revolution, “supply-side” economists have dreamed of cutting tax rates without actually reducing government revenues, so as not to increase the federal deficit. In theory, that could be accomplished if tax cuts stimulated economic growth and increased the income base from which taxes are collected. In practice, Republican tax cuts since Reagan have not paid for themselves, and the annual deficit has risen under Republican administrations while falling under Democratic administrations. (The total national debt, however, has risen under both parties’ administrations, since only rarely has the government run a surplus. Bill Clinton did toward the end of his presidency, but then George W. Bush used the surplus as an excuse for another round of tax cuts and deficits.)

Since middle-class tax rates are already fairly low, the middle-class tax cut is probably too small to produce much stimulus. Those who believe in top-down economic growth are pinning their hopes more on the corporate tax cut. That could translate into widespread income gains, but only if corporations actually invest the money in expansions of output (as opposed to just distributing it in dividends to mostly wealthy shareholders or buying up existing assets), and spend a lot of it on labor, not just on labor-saving machinery.

What the country needs is a virtuous cycle of higher productivity and higher wages. Higher productivity justifies wage increases, and higher wages create the consumer demand that justifies investment in the expansion of supply. What is missing from the Trump economic policy, and from Republican policy in general, is much support for higher wages. That would mean federal support for workers in their efforts to bargain for a fairer share of the income gains the economy is capable of generating. For a man who presents himself as a friend of the working class, Trump has remarkably little to say on this subject. In a way, he is the personification of trickle-down economics, the billionaire who just asks people to trust rich folks like him to create wealth for the masses.

We get occasional hints that President-Elect Trump might depart from the standard Republican playbook of tax cuts for the wealthy and spending cuts for everyone else. His interest in infrastructure spending and his Treasury secretary’s support for concentrating tax cuts on the middle class are hopeful signs. But overall, I remain skeptical that much that is good for working families will survive Trump’s embrace of Wall Street and the Republican establishment.