In 1981, as the Economic Recovery Tax Act was being passed, Murray Weidenbaum, President Reagan's first chairman of the Council of Economic Advisers, asked me, "What other administration had its anti-recession package In place before the recession?" Unfortunately, the act did not come into full effect until late 1982, by which time unemployment had risen to 10.7% and the country had fallen into its deepest recession since the 1930s. Today, the question is whether an economic package can be put together in time and have sufficient force to stave off the looming recession. And the answer, in large part, depends on how willing we are to listen to John Maynard Keynes.Macroeconomic Theorists
Take the recent cut in the Fed Funds rate to 5.25% from 5.5% undertaken in the face of foreign dangers and signs of a slowdown in the U.S. economy. This is straight out of Keynes. His "The General Theory of Employment, Interest and Money," first published in 1936, urges that interest rates be kept as low as possible to encourage business investment, maintain demand and employment, and promote growth. But Keynes saw a limit to what monetary policy alone could do to combat a recession, as interest rates can be driven only so low. Stimulatory fiscal policy is also necessary.
Then take recent developments abroad. In Japan. Prime Minister Keizo Obuchi has proposed a $100 billion package of tax cuts and increased government expenditures to bring the country out of its long recession. In recessionary Germany, it seems likely that, with the arrival of the euro and the virtual disappearance of inflation, the Bundesbank may abandon its longtime commitment to a tight monetary policy. Spain's cut of 0.5% in its benchmark interest rate last week seems indicative of the new directions. And the reduction in measured budget deficits throughout Europe leaves more room, within the tight limits imposed by the Maastricht treaty, for new fiscal stimuli.
Many insist that a tax cut- the government taking less from the public- is fine, but an expenditure increase- the government giving more to the public- is bad. Such a position seems to be based more on an ideological commitment to smaller government than on a reasonable judgment about what constitutes an effective stimulus. It also relates to the question of who is most likely to benefit from an increase in government outlays as opposed to a cut in taxes. But whether from the demand or the supply side, tax cuts and increased government expenditures are- both can readily be made- mathematically equivalent.
For example. cutting taxes on Social Security recipients is similar to increasing their gross benefits. In either case, retirees have more to spend. Similarly, cutting payroll taxes for low-income workers is essentially the same as enlarging the earned-income tax credit, which can entail actual cash pay outs. Both of these measures increase purchasing power and private spending. Both also have supply-side effects, as the incentives to take jobs rise and the cost of labor to employers goes down.
In practice however, there are substantial differences between the beneficiaries of tax cuts and the beneficiaries of expenditure increases. In 1996, those with adjusted gross income less than $30,000 paid less than 9% of total income taxes. Millions filed no returns at all. But those with incomes over $50,000 paid 78% of the total, and those who made over $200,000 paid 34%. Thus, the vast middle class receives few if any direct benefits from general cuts in income taxes. Cutting estate taxes, an other current proposal, would directly benefit only the tiny minority wealthy enough to face such taxes. No more than 83,000 estates paid taxes in 1995, less than 4% of the number of people who died that year.
By contrast, many increases in government outlays, whether for health education or infrastructure, offer direct benefits to the general population and sometimes, though not always, disproportionately large benefits to the relatively indigent. And this matters to the effectiveness of the stimulus.
Thus, from the demand side, cuts in taxes are unlikely to affect the spending habits of millionaires, whereas increases in the disposable income of low-income people do affect their spending, as they have little choice but to spend every dollar they receive. As for the supply side, it is doubtful that a tax cut would stimulate labor productivity among the wealthy. Where tax cuts do matter is among the poor, who for now are quite reasonably unwilling to trade the benefits of Medicaid, food. stamps and rent subsidies for low wage jobs that would leave them worse off.
A distinction must also be made between increases in government outlays in the form of transfer payments such as Social Security and unemployment benefits, and increases in direct government outlays for goods and services such as the military, roads, schools and so forth. The latter entail direct increases in gross domestic product and employment rather than a stimulus that is derived entirely from greater private spending.
It must also be recognized that temporary changes in Income taxes or transfer payments are likely to have less of an impact than those that are viewed as permanent. Short-run increases in income, particularly for the affluent. are often put aside for the future, and thus have little immediate impact on levels of consumer spending. By contrast, temporary tax cuts or subsidies for business investment, new housing or durable goods would have a powerful anti-recessionary impact, and could be removed when no longer needed. And we might also act on the advice we are giving the Japanese, increasing spending on infrastructure as well education, health, and anything else we consider useful.Keynesian Solution
Whether they credit Keynes or not, policy-makers have the tools to prevent International events from triggering a recession in
the United States. But stimulative measures must be taken promptly; after all, it is harder to stop a boulder from rolling down a
hill after it has gained momentum than to shore it up before it begins its fall.