Embarrassing Error In Economics Textbooks Has Major Impact On Policy

If you were to examine virtually any economics textbook currently used to teach Econ 101 in college classrooms, you will find “Tax Cuts” listed under the heading of “Tools of Expansionary Fiscal Policy.”

It is an unfortunate error of great significance, for it is at least partly responsible for the failed experiments with Austerity that we have witnessed in recent years on both sides of the Atlantic (at great human cost).

To an economist, the macroeconomy is a vast ‘problem’ containing dozens of economic ‘variables’ that they would like to be able to make some sense of.

One of their most basic scientific goals has been to state with precision what kind of impact on the economy’s overall performance we should be able to expect when certain of those economic variables is changed (increased/decreased).

This is not always the easiest thing in the world to do, for there are usually more than a few economic variables involved, and that can make it very difficult to say which variable is responsible for what percentage of the changes we are seeing in the overall economy.

To make this challenge less daunting, social scientists make full use of the cereris paribus assumption, wherein they assume for analytical purposes that all other economic variables are held constant.

If we assume that no other economic variables are allowed to change, we are then able to isolate the impact that a single changed variable is responsible for with respect to the overall economy.

It is an analytical approach that is invoked quite frequently in the typical introductory Economics textbook, but for some reason, it is utterly ignored when lists are compiled of those fiscal policy initiatives which are said to be expansionary vs. those which are said to be contractionary.

I find it incredible that mainstream economists have never bothered themselves to identify—-for the record—-what the isolated effect is that a tax cut has on the economy, when all other economic variables are held constant.

In other words, if you cut taxes, but do nothing else (e.g., do not borrow money to maintain government spending), what will the ‘pure effect’ of a tax cut be on GDP? Answer: it will decline.

Tax cuts are contractionary because governments cannot spend money that they do not have. If taxes are cut and nothing else is done to sustain government spending, then government spending is going to drop by the amount of the drop in tax revenue.

Because not all of the tax ‘refund’ will be spent (some of the money will be removed from the economy by savers), the increase in consumption C generated by the tax cut is going to be less than the drop in government spending G that will also be caused by the tax cut.

That, my friends, is what we call a contractionary effect, a caused drop in GDP that is initiated solely by a reduction in taxes collected.

Raising taxes, on the other hand, is expansionary if at least some of the tax revenues collected by the government would have been saved. The increase in G is greater than the drop in C.

Money that would otherwise have been removed from the economy by savers is spent, instead, by the government. The result is a net increase in aggregate demand, in GDP, and that is the very definition of the term ‘fiscal stimulus.’

It is true that if the government cuts taxes while maintaining its spending levels with borrowed funds, a net stimulus to the economy is generated, but none of the increase in GDP effected by this fiscal policy ‘combo initiative’ can be rationally attributed to the tax cut.

All of the stimulus effect we would observe would be derived from the spending of borrowed money, money that had been removed from the economy by savers.

Tax cuts BY THEMSELVES are always contractionary (or at least, never expansionary). But when the government borrows money to finance a tax cut, the stimulative effect of spending borrowed money is usually enough to overcome the contractionary effect of the tax cut (sometimes only barely: see The Bush Years).

The rational alternative to Austerity is for the government to reduce its high levels of indebtedness through increased government spending financed by tax hikes on rich people.

Imagine, for example, if equal amounts of additional revenues generated by a tax hike were spent by the government on (1) entitlement spending and on (2) new spending on infrastructure.

The new tax revenues spent on ‘old spending commitments’ would reduce the government’s total borrowing needs by an equal amount.

The new tax revenues spent on new infrastructure would provide a true economic investment to the nation at the same time that government debt is being reduced.

Again, the consumption C of rich people would drop, but it would be more than made up for by the increase in government spending G that would also occur.

The empirical evidence available supports the claim that tax cuts are contractionary and tax hikes are stimulative, especially when the tax cuts/hikes affect primarily rich people.

Paul Krugman put together a nice graph a couple of years ago that illustrates this cause and effect relationship:

It is not at all surprising that Republican/Conservative economists would advance specious arguments to justify their policy proposals.

But what excuse do ‘left-leaning’ economists have for meekly accepting the clever political efforts of right-wing economists to depict their contractionary agenda (tax cuts) as stimulative by combining it with an initiative that actually is stimulative?

(…and then they turn around and condemn the one thing that makes a tax cut economically justifiable and politically palatable: the borrowing...)

I can only hope that one day lefty economists will match the political saavy of Republican/Conservative economists and take away their specious “tax cuts stimulate the economy” claim.

We need to get those textbooks rewritten and we need to educate the Journalist Class re: the contractionary effects of tax cuts. The corrupted financial mavens of both Europe and America would still pass out the same bad advice to policy makers, but at least Republican politicians would no longer be able to get away with repeating their favorite Big Lie without consequences.

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