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Saturday, December 2, 2017

Republicans Cut Taxes. Sun Rises In The East.

At the time of writing, it appears that the Republican-controlled Congress will be able to patch together a tax cut bill. What exactly will be in the bill is still unknown; you gotta pass the law to see what's in it. Based on the chatter I have seen, it seems likely that the tax cut will not have a major macroeconomic impact, although it might help trigger rate hikes. This cut has raised in an interesting debate within the Democratic Party: should they follow the same strategy that has failed for decades, or take a MMT line on the topic?

Macro Impact

Once again, it is very unclear what tax cut bill will ultimately be passed. The bill is unpopular, and the legislative process around it can only be described as chaotic. (This process is completely foreign to me. In Canada, the budget is written up by presumed adults for the Minister of Finance, and then the budget is rammed down the throat of Parliament.)

However, my guess is that the final bill will mainly consist of tax cuts aimed at businesses and the wealthy, with minor tax increases for everyone else.

In analysing the bill, the dollar cost is essentially a piece of trivia; what matters is how many jobs would be created. Needless to say, those estimates would largely reflect the biases of the forecaster. My bias is that very few jobs would be created, and so the tax cut is not a big deal.

Effect on Inflation

One of the problems with mainstream analysis is that it relies on highly aggregated analysis -- a single household sector, with a single unemployment rate. That was the point of failure of the Old Keynesian economists, and the New Keynesians learned the wrong things from the Old Keynesians' failures.

If we have a more realistic analysis, there are two offsetting factors in the tax cut.

  1. The tax cut is aimed at entities that have a low propensity to consume. The net stimulus would be small.
  2. However, the stimulus will be hitting the sectors/regions of the economy that were already doing well. This would cause sectoral inflation.

My guess is that the effect on measured inflation would be small. The reasoning behind this guess is straightforward. The spending of the ultra-rich does not appear to show up measured price indices; if it did, we probably would have had higher inflation rates already. Very simply, private jet prices do not have an impact on the CPI. Since policy is aimed at aggregates like the CPI, the observed effects would be very hard to disentangle from the expected effect of the cycle -- inflation rates generally rise during the cycle.

Interest Rate Offset

It is interesting that many liberal mainstream economists are worried about the economy overheating, even though they subscribe to the theory that the central bank will just offset the effect of stimulus. If we were to believe mainstream theory, the central bank will raise rates to counteract the stimulative effect of the tax cut.

However, that is exactly what mainstream economists were asking for just a few years ago: we need to get interest rates away from zero, so that we can avoid the "liquidity trap" (their definition).

Furthermore, higher rates are exactly what pensions need. Decades ago, most developed countries pinned their hopes on pension plans to provide retirement income. Such plans would obviously run into trouble if we had a long period of negative real rates. However, mainstream economists almost certainly assured people that it was impossible for real interest rates to be negative for a long period of time -- the natural rate of interest is positive! (I do not know whether they said that about pension provision, but they certainly said the negative real rates of the 1970s were an aberration.)

"But We're At Full Employment!"

One strand of argument against the tax cut is that we are already at full employment. Since there is actually no good empirical evidence about what "full employment" represents (using the mainstream definition), this argument is full of holes. Starting in 2010, I had to sit through presentations by economists arguing that the United States was already at full employment.

Since there are no reliable estimates of full employment, the argument really boils down to said economist not liking the tax cut.

Probability of a Debt Crisis

The probability of an involuntary default by the United States Federal Government will rise to 0% (from 0%) as a result of this tax cut.

Political Strategy

For decades, the Republicans have followed the strategy of "starve the beast." Cut taxes, and then use the public's irrational fears of debt levels to force through spending cuts. The size of the government (other than defense spending!) is steadily ratcheted lower.

This strategy obviously requires lying to the public, which offends many people. I come from a political environment where politicians routinely said one thing in French, and the opposite in English (when language tensions are high); nobody really bats an eyelid. Politicians lie; that's part of their job description. (I would note that I am a Prairie Populist; my favoured politicians did not lie. I just have very low expectations for other politicians.)

The traditional Democrat response to this strategy has been to emphasise how unsustainable Republican tax cuts are. In the current environment, this will have the predictable response: spending on programmes favoured by the Democrats will be cut by the Republicans, in the name of fiscal responsibility. Since the programme being cut almost certainly have a higher multiplier than the tax cuts, we end up with a net fiscal drag, with the negative effect aimed at the weaker sectors and regions of the economy. In other words, the Democrats help legitimise starving the beast.

From the perspective of Modern Monetary Theory, the dollar amounts do not matter, only the effect on the real economy. It is very easy to question what purpose is served by cutting taxes on the cohort that has had the greatest income recovery since the financial crisis. The Republicans won the election, and should be expected to enact their preferred agenda. However, they need to be held accountable and forced to justify the effects of that agenda, and not be derailed about arguments over mythical debt crises (which they will win).

(c) Brian Romanchuk 2017


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