Retirement and Social Security Reform
Comments on JCT Efforts To
Economic and Budget Effects Of Fiscal Policy Changes
For Research On the Economics of Taxation
By Stephen J. Entin
"Essays In Supply Side Economics", edited by David
Raboy, published by IRET, gives a good discussion of the differences
among Keynesian, monetarist, neo-classical and rational expectations
theories. It will help people to understand what neoclassicists
are thinking and whether a model is in line with the supply
side or neo-classical approach. It is available on the IRET
under the heading "supply-side economics".
Three chapters are particularly useful. "Supply Side
Economics and Public Policy", by Norman B. Ture, highlights
the focus of Supply Side economics on the relative price effects
of fiscal policy changes, and makes the key point that there
are no first order "demand" effects from a tax rate
"The Theoretical Heritage of Supply Side Economics"
by Raboy is an interesting discussion of the roots of supply
side and Keynesian economics. He traces supply side thinking
back to Smith, Say, Marshall and the marginalists, and traces
Keynesian and post-Keynesian philosophy to Malthus. It serves
to suggest that economic analysis based on relative price
effects, far from being a peculiar recent development, is
the mainstream of economic thinking.
"Rational Expectations and Supply Side Economics: Match
or Mismatch?" by David G. Tuerck, may be the most useful
for the present discussion. It demonstrates that rational
expectations and supply side theory are compatible. In particular,
it reminds us that the rational expectations view of the ineffectiveness
of fiscal policy in altering long run real activity refers
to fiscal policies that seek to affect real output through
manipulation of aggregate demand. As William Fellner observed,
"Rational expectations reduces to two fundamental propositions:
(1) that the systematic or anticipated components of government
demand-management policy will be neutral with respect to real
economic variables and (2) that demand management policies
aimed at influencing those variables will, therefore, be ineffective."
(Essays, p. 91.) Nota bene: this does not imply that relative
price effects of fiscal policy will be ineffective.
Labor elasticity of supply.
Jane Gravelle has offered a paper reviewing literature on
labor supply elasticities. It seeks to answer the question
of the relationship between income and substitution effects
on labor supply. Jane would like us to assume that labor elasticities
of supply may be close to zero. (Note: if it were, then we
would be better off imposing all taxes on labor and none on
returns to elastically-supplied capital!) Much of the analysis
in the literature that is reviewed looks at labor force behavior
over time. This research is misdirected and is irrelevant
to the real question.
It is sometimes stated that reductions in marginal tax rates
would have little effect on hours worked because the workers
would have higher disposable incomes as well as a new trade-off
between labor and leisure. The positive income effect would
lead them to reduce hours worked. The reduced time cost of
earning income to buy market goods and services, and the corresponding
higher opportunity cost of an hour of leisure, would cause
them to work longer. Which effect would dominate is an empirical
question that could go either way. We may be on the disadvantageous
side of a "backward-bending supply curve of labor".
Supply side, monetarist and rational expectations theory
would all disagree. A supply curve is a schedule of the quantities
of a product or service, including labor services, that would
be supplied if the suppliers were offered various amounts
of compensation at a moment in time, other things equal. In
the case of the supply of labor, that means a constant population,
capital stock, technology, and level of skill of the workforce
and management. Consequently, at a point in time, the workforce
cannot have, simultaneously, more leisure and more real output
simply because tax rates have been reduced. Unless the workforce
responds to the lower tax rates by working more, there will
be no added output, and since output equals income, there
will be no added income, and therefore there will be no added
income out of which to "buy" more leisure. There
is no first order income effect from a tax reduction; that
is, there is no immediate change in income from the tax cut
per se, and income is not the channel through which the tax
cut alters economic behavior. Income increases only if there
is first a positive input supply response due to the relative
price effects, in which case aggregate supply, output, income,
and demand will subsequently rise together.
The only way that the whole country or world can work less
and still have more goods and services is for capital deepening
or technological advances to boost productivity. That takes
time. Over time, productivity and income can grow, and people
can increase their consumption of leisure and of market goods
and services too, and will do so because both are "normal
goods" whose consumption rises with income. Even so,
at any single moment in that time period, people would work
more for a higher reward. It is no contradiction to say that
people will work longer at any point in time if their tax
rates are cut because the reward to work increases, and to
observe that, as technology, productivity, and real incomes
advance over time, people take more leisure.
At a point in time, the production technology ensures that
there is no immediate income effect from a tax cut, but many
analysts are used to thinking in terms of money flows, rather
than real variables. So let's think that way. One might note
that, in a tax/transfer system, the income effects of a tax
rate change cancel out, and all that are left are the substitution
Monetarists would point to the government budget constraint,
and point out that there is no demand effect unless the Federal
Reserve buys the added government debt, which is a change
in monetary policy, not fiscal policy. Otherwise, the government
would borrow back with one hand what it gave out with the
other. "Disposable income" might go up, but disposable
income less what we put into the government bonds and had
left to spend on other stuff would not.
Friedman would further point to "sticky consumption"
and permanent income theory to suggest that the tax cut would
be saved. Rational expectations theorists would point to the
need to save the tax cut against the day when taxes would
go up to recover the lost revenue. The tying up of the "static"
revenue loss of tax cuts on existing levels of income, due
to the need to save the tax reduction on that amount of income
to repay the government at some future time, however, does
not eliminate the relative price changes that result from
the tax rate cut that increase the reward for additional units
of output by imposing less tax on the associated additional
income. As for the tendency to buy leisure, there will not
be any additional income unless people respond to the incentive
to produce more output. Until they do, there is no added income,
and nothing but the relative price effects.
The backward bending supply curve of labor can only exist
at a point in time for a subset of the population, or for
a society as a whole over time (in which case it is not a
true supply curve, but a string of points illustrating a set
of curves shifting over time).
Suppose everyone puts a dollar into the Big Game lottery,
and I win! I will certainly work less, due to my sudden positive
income effect. Everyone else who played the Game, however,
will have to work a bit more because they lost the dollars
they contributed to my winnings (and to the states that took
their cuts), and had negative income effects.
Take the textbook example. Suppose Alcoa opens a bauxite
mine in Jamaica, and pays its workers North American wages,
well above the Jamaican prevailing wage. Those few workers
can earn more working fewer hours, and can buy more goods
and more leisure, than they could before the mine opened.
But that added income came from the additional capital investment
done by the company, a transfer of capital into the island,
which boosted productivity and output. The workers' shares
of the added income allowed them to buy goods produced by
their fellow Jamaicans, or imported from foreigners, who still
have to work to produce them.
After CBO Director Alice Rivlin made the "negative
income effect" argument in the late 1970s in an analysis
of proposed marginal tax rate reductions, Paul Craig Roberts
pointed out an amusing implication. Marginal tax rate reductions
lower the relative price of market goods and services and
raise the relative price of leisure. For the public to respond
to the drop in the price of goods and services by taking so
much added leisure that production and consumption of goods
and services would fall would suggest that market goods and
services are, collectively, Giffen goods. Giffen sought to
find an example of a good in which the income effect of a
price change outweighed the substitution effect by looking
at the case of bread consumed by the poor, which was all they
could afford and which took up most of their income. A fall
in the price of bread might let them buy a chicken which would
substitute for a bit of the bread. Even that example did not
pan out. Since we have never been able to identify even one
Giffen good, the CBO contention seems unreasonable. Roberts
asked Dr. Alice Rivlin if she or her staff could resolve the
paradox. He never received a reply.
The paradox is resolved, of course, by noting that there
can be no first order income effect from the tax cut. That
also resolves the paradox of the short term and long term
labor supply response to tax cuts. Since there are no first
order income effects from a tax rate cut, labor supply elasticities
must always be positive with respect to the after-tax wage.
Any aggregate labor supply curve is upward sloping. This does
not conflict with the observation that aggregate labor supply
curves shift upwards over time as productivity and real incomes
rise (requiring a higher wage to bid people out of leisure).
Federal Reserve policy.
It is unreasonable to model the Federal Reserve as pursuing
a perverse monetary policy determined to offset any real growth
stemming from reductions in the distorting effects of high
tax wedges. That would be directly contrary to the Fed's charge
under the Humphrey-Hawkins Act to promote growth and low unemployment
while maintaining price stability.
Years ago, the Fed may have believed that fiscal factors
unrelated to prior bursts of money growth could cause inflation,
but that "demand side" notion is outmoded, even
at the Fed. Greenspan has been forthright in admitting that
productivity gains have made faster growth possible in recent
years, and have permitted him to keep money growth faster
than would otherwise have been the case. Unlike the Fed of
the Martin-Volcker era, Greenspan and at least some of his
colleagues know that deficits are not "stimulative"
in the old Keynesian sense in the absence of Fed accommodation.
Even if the Fed were not yet up to speed on this idea, the
research and modeling being done to permit dynamic scoring
of tax changes will, presumably, set that record straight,
and reveal that favorable shifts in the aggregate supply curve
are, ceteris paribus, disinflationary. Assuming the JCT makes
its model available to the Fed along with other researchers
and policy people for examination and elucidation, and they
will not make that kind of policy error. By showing them what
monetary policy works best with this new view of fiscal policy,
the JCT effort will guide them to the right monetary policy,
and will not need to assume the wrong one. It would be appropriate
to illustrate the damage done by wrong policy, but the exercise
should also demonstrate the beneficial impact of the right
policy, and label it as such.
Such open communication with the Fed will avoid errors like
1966-67, when model projections of inflation from the Kennedy
tax cuts and the Vietnam build-up caused the Fed to tighten,
and gave us a mini-recession before the Fed scrambled to reverse
course. It seems that none of the model builders had told
the Fed that the models had assumed the Fed would accommodate
the deficit, and that was the channel through which the supposed
fiscal stimulus would work. The Fed assumed the models were
showing inflation and stimulus from the fiscal policy changes
alone, even if the Fed did not accommodate with easier money.
So the Fed leaned against an inflationary wind that was not,
in fact, blowing, and then had to reverse course. The Fed
learned from that, and learned again in 1981-85, when tax
reductions helped disinflate the economy unexpectedly fast
by lowering the tax wedge on inputs.
Remember, in a neo-classical framework, the Fed is supposed
to focus on price stability, and has limited influence on
real variables. They should behave accordingly, and take their
cue from various price indices. They should not expect demand
to outstrip supply in a neo-classical world, as the two only
rise together (since there are no income/demand effects from
a tax cut unless people respond by offering more inputs and
producing more output).
The Fed should focus on prices, not interest rates, because
if tax reductions boost the real return to physical capital,
financial market interest rates would rise in tandem, and
efforts to hold rates down might cause the Fed to create too
much money. And if the Fed gives up on "inflationary
gap" and demand theory, there is no rational theory or
operational variable that would lead the Fed to slam on the
brakes, either. Following an incentive tax cut, added output
chasing the existing money supply would tend to lower prices.
Therefore, the Fed should expand the money supply in step
with the growth of real output and with the resulting demand
shift for money balances, to maintain steady prices. Following
a non-marginal, non-incentive tax cut, the Fed should assume
no demand effects, no added growth, and no change in the price
level, and it should not change its policy. No other Fed policy
and no other assumption about it make sense.
Offsets to rebalance the budget down the road.
The best approach is to model the tax cut or spending increase
and show the result for the budget with no additional policy
changes. That would show politicians and everyone else the
magnitude of the impact on the budget, ceteris paribus, and
without having to select one future offset as inevitable.
(Of course, if the exercise begins at a time of surplus,
and the tax cut, after reflows, leaves the budget in balance
or so slightly in deficit that debt service is not crowding
out other spending, there is no need for any future action
in the real world. The tax cut would reduce the future surpluses
available for spending increases, but would not threaten the
budget. In the world of the model, the supply side real output
deltas from the tax rate changes should not depend on the
starting point, however; the same change in the after-tax
wage and cost of capital should have the same outcome regardless,
so long as the rate changes are in effect.)
The model should show the changes for various fiscal shifts
consistently, basing the impacts on their relative price effects
as in a neo-classical model, not on Keynesian demand effects.
Presumably, incentive-improving tax cuts (that lower the cost
of capital and raise the after-tax wage at the margin) would
show some added economic growth and some revenue reflow, reducing
the gap to be closed by future spending cuts (or less spending
growth) or future tax increases. That is, spending would not
have to be cut dollar for dollar with the static-measured
cost of the tax cut. Non-incentive tax cuts (not at the margin
and having no effect on the cost of capital) would show no
growth, and a larger future gap to be closed by future dollar
for dollar spending cuts (or less spending growth) or tax
increases. Spending increases (other than very productive
infrastructure outlays) that absorb resources that would otherwise
be available to the private sector (in part to increase capacity)
would also show either no growth or a reduction in growth,
and no revenue reflow or a net reduction, and would show a
large future gap to be closed by spending cuts (or reduced
spending growth) or tax increases. Increased transfer payments,
especially those with phase-outs, would show disincentive
effects and reduce output and revenue.
If future policy offsets to a current period tax change
are modeled, the JCT should be consistent with the model,
and show the results of the various types of offsets. It should
show the effects of a disincentive generating tax hike (at
the margin and raising the cost of capital), a non-disincentive
generating tax hike (not at the margin and not raising the
cost of capital), and various spending cuts. The spending
cuts should be ones with no adverse real effects (cuts in
government consumption or ineffective investment), or beneficial
effects (cuts in transfers that discourage work and saving).
The spending cuts should not just be of the "let's stop
building roads and bridges and anything else productive and
scare the pants off the Congress" sort of example --
a sort of "Washington Monument Syndrome" applied
to tax modelling.
Note that spending cuts would allow for budget rebalance
without offsetting the growth effects of incentive tax reductions.
Note that closing a spending-induced budget gap with future
disincentive tax increases would show a future hit to the
economy, after no gains from the initial spending hike. These
results are an indication that the spending cost more than
its static budget outlays. Also, in the case of a tax cut,
if failure to restrain spending to pay for the net-of-reflow
tax cut forces future tax increases, the future loss of the
real output and income gains must be added to the dollar cost
of the spending to get a true measure of the cost of the spending.
As long as the JCT treats spending and taxes consistently,
it would not distort the picture being painted of the relative
merits of the various policy options.
Open versus closed economies.
The U.S. economy is part of the world economy. Capital flows
very freely across borders, and even labor is somewhat free
to move about. The model should clearly reflect this reality.
There should be no exaggeration of the very limited impact
of U.S. deficits per se on market interest rates. The notion
that policy makers abroad would move quickly to enact competing
tax cuts to prevent any net flow of capital to the United
States is not based on historical evidence. After the Thatcher
and Reagan tax cuts, it was years before other nations followed
suit. The U.S. has also failed to respond to the reduction
in corporate taxes in most other OECD nations over the past
decade, to the point that the U.S. corporate tax rate is now
fourth highest in the OECD (and about to become second highest
as others continue to cut).