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Tuesday, November 25, 2008

No Stimulus in Government Spending

Arthur Laffer is a well known supply side economist and he was one of the main architects of Reaganomics. He is most famous for the Laffer curve.

In economics, the Laffer curve is used to illustrate the idea that increases in the rate of taxation do not necessarily increase tax revenue. (For instance, a 100 percent income tax will generate no revenue, as citizens will have no incentive to work). Increasing taxes beyond the peak of the curve point will decrease tax revenue. The Laffer curve was popularized by Arthur Laffer (b. 1940) in the 1980s. However, the idea is not new to him. In his General Theory of Employment, Interest, and Money, John Maynard Keynes described how past a certain point, increasing taxation would lower revenue and vice versa.[1

The Laffer curve stated that there was an optimum level of taxation that would both not mitigate productivity and also maximize tax receipts. Today, Laffer writes an interesting piece bemoaning the idea that government spending would stimulate the economy.

It is true, as the proponents of these stimulus packages argue, that recipients of government checks will spend more than they otherwise would have spent. And, that increased spending will have a multiplier effect increasing spending even further. But this is only part of the story.

The government can only transfer resources; it can’t create resources. There is no tooth fairy. Every dollar given to someone comes from someone else. The government can’t bail some people out of trouble without putting other people into trouble, plus a hefty “toll for the troll.”

This is an excellent point about the futility of stimulus checks. The government issued an extra $170 billion in U.S. government bonds to send out these checks. While some of these bonds were bought by foreign entities, most of them were bought by Americans. In other words, this stimulus merely transferred money from those that bought the bonds to the tax payers at large. On top of this, the government now owes interest on all of these bonds. In effect, this was a net loss and that as good an explanation as any for why the stimulus of last February failed to stimulate the economy.

From the standpoint of accounting, the government is $170 billion further in the red, and taxpayers are liable for an additional $170 billion worth of taxes. Therefore, for every dollar of transfer payment there’s at least an equivalent dollar of future tax liabilities. Those people with the increased tax liabilities will spend less, thereby dis-employing people who had been supplying them with goods they’ll no longer buy. And the reduction in spending of those with higher tax liabilities will lead to a multiplied reduction in total spending equal to and fully offsetting the increase in total spending from the recipients of government checks. There is no stimulus from the stimulus programs!

To see this point more intuitively, imagine what the “stimulus effect” would be if they borrowed the $700 billion from the same people to whom they gave the $700 billion and then promised to raise their taxes by enough in the future to pay off their bonds. Where’s the stimulus in that?

This point is hugely important. For the proponents of increased government spending to argue that their policies will increase output, it is absolutely essential that the increased spending by transfer recipients more than offset any decline in spending by others. If the income effects of fiscal policy net to zero, there is no rationale for these spending policies. And, the income effects of fiscal policy do indeed net to zero.

Now, here Laffer makes an excellent theoretical point however in practice it may or may not hold water. Laffer's point is that any stimulus which would be borrowed, of which this would be, would be offset by everyone spending less that would wind up being taxed more to pay for said stimulus. In practice, no one yet has had their taxes raised. As such, no one should be minimizing their spending because no one's taxes have been raised. Furthermore, defenders of stimulus through government spending would argue that taxes would only be raised on those wealthy enough to have stopped spending long before the tax increase. For this, Laffer has a rather vague and confusing response.

The diffuse and imprecise nature of just who bares the increased tax liabilities makes the point difficult to understand. We all know who benefits from government programs: mortgage holders, undercapitalized banks, auto companies, low-income earners and the like. But who bears the increased tax burden? That’s a far trickier question, the answer to which I don’t have. But in the aggregate I do know that for every beneficiary of government spending there is someone who has to pay for it. As Milton Friedman so wisely noted, “There ain’t no such thing as a free lunch.”

What I don’t really know is just how far this process can go and just what it will take to stop this vicious cycle. Combine the unintended consequences of a flawed model with a crashing economy in ever more desperate need of beneficial policies, and the results are lethal. The old adage “if you don’t like government problems just wait till you see government solutions” has never been truer.

If we don't know who is going to bear the burden, then why would those folks stop spending. Furthermore, defenders of this policy would say that taxes would be raised when the economy has recovered and is need of a tax increase. Still, Laffer makes a very simple and important point...government creates nothing, but rather it transfers it. That's an important thing to keep in mind as we watch all of this government stimulus evolve.

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