Tag Archives: Feldstein

The Return of Voodoo Economics

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Paul Krugman’s column in the New York Times today talked of the revival of “Voodoo economics” by some Republican politicians.  This refers to the Laffer Proposition that a cut in income tax rates stimulates economic activity so much that tax revenue goes up rather than down.   Gov. Sam Brownback, who is running for re-election in Kansas, has had to confront the reality that tax revenues went down, not up as he argued they would, when he cut state tax rates.

I disagree with one thing that Krugman wrote in his column: the idea that there was a long break,  particularly after George W. Bush took office, during which Republican politicians did not push this line.  To the contrary, I have collected many quotes from George W. Bush and his top officials claiming the Laffer Proposition during the decade of the 2000s.   The quotes are on pages 35-39 of “Snake-Oil Tax Cuts,” RWP 08-056, Harvard Kennedy School, 2008.   Here is one of many from him: “The best way to get more revenues in the Treasury is…cut taxes to get more economic growth.“ It is true that the chairmen of Bush’s Council of Economic Advisers did not support the Laffer Proposition, known as the centerpiece of “supply-side economics”.  But then that was also the case in the Reagan Administration.

The McCain presidential campaign replayed the pattern yet again in 2008: the candidate said tax cuts would bring in more revenue even though his economic adviser said it wouldn’t.    Voodoo economics is a very hardy perennial.

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Four Magic Tricks for Aspiring Fiscal Conservatives

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Politicians who advertise themselves as “fiscal conservatives” sometimes campaign on crowd-pleasing pledges to cut taxes and simultaneously reduce budget deficits.  These are difficult promises to deliver on in practice, since the budget deficit equals government spending minus tax revenue.

Aspiring fiscal conservatives may be interested in learning four innovative tricks that are commonly used by American politicians who like to promise what seems impossible.   Each of these feats has been perfected over three decades or more.  Indeed they first acquired their colorful names in the early years of the Ronald Reagan presidency:

1. The “Magic Asterisk”
2. “Rosy Scenario”
3. The Laffer hypothesis
4. The “Starve the Beast” hypothesis.

As shop-worn as these four conjuring tricks are, voters and journalists continue to fall for them. Thus they remain useful equipment in the repertoire of the fiscal conservative.

The first term was coined by Reagan’s Budget Director, David Stockman.  Originally it was an act of desperation, because the numbers in the 1981 budget plan didn’t add up.  “We invented the ‘magic asterisk’:  If we couldn’t find the savings in time – and we couldn’t-we would issue an IOU. We would call it ‘Future savings to be identified.'” [p.124]   Since that time the Magic Asterisk has become a familiar device in the American policy arena.   Recent examples include the recommendation of the Simpson-Bowles commission to cut real spending growth by precise amounts, without saying where.   US Presidential candidate Mitt Romney has done the same in his spending plan.    Another current application of the Magic Asterisk is Romney’s plan to eliminate enough tax expenditures to make up the revenue lost by cutting marginal tax rates by 20% (which is $5 trillion in revenue), while steadfastly refusing to say what tax expenditures he would eliminate.

As Election Day nears, the pressure on a candidate to get more specific grows.  The conjurer is thus forced to go to Trick Two:  since he can’t find enough tax loopholes to eliminate, he must claim that what he meant by closing the revenue gap was that stronger economic growth will bring in the added revenue.   The most popular magician’s assistant of all time makes her encore on the stage.  Murray Weidenbaum, Reagan’s first Council of Economic Advisers Chairman, deserves the credit for originally dreaming up Ms. Rosy Scenario, “perhaps my most lasting legacy” [p.57].  The Reagan Administration in its early years forecast 5% income growth (twice the long-run average), in order to imply in its projections a boost to revenues big enough to make up for its many tax cut measures [p.93-97].   Since then candidates of every party have made use of Rosy’s talents.

Indeed official growth forecasts are systematically overly optimistic in almost all of a sample of 33 countries, contributing to overly optimistic budget forecasts.   European governments are particularly biased.

In the Republican primaries last year, candidate Tim Pawlenty assumed a 5 per cent growth rate to make his own plan work.   He was all but laughed out of the race.  Mitt Romney probably can’t get away with this sleight-of-hand either.   The press asks, “Why should we believe that the growth rate will magically accelerate just because you become president?   Where will this GDP come from?   It sounds like pulling a rabbit out of a hat.”  Right on cue, it is time for Trick 3.

Trick 3 is the famous Laffer Hypothesis.   This is the proposition, identified with “supply side economics,” that reductions in tax rates are like magic beans:  they stimulate economic growth a lot — so much so that total tax revenue (the tax rate times income) goes up rather than down.   One might think that the Romney campaign would never resurrect such a hoary and discredited trick.  After all, two of his main economic advisers, Glenn Hubbard and Greg Mankiw, both have textbooks in which they say that the Laffer Hypothesis is incorrect as a description of US tax rates.  Mankiw’s book, in its first edition, even called its proponents “charlatans.”  But the historical record is that each Republican presidential candidate since Reagan has had good economic advisers who disavow the Laffer Hypothesis.  Yet time and again the president (or candidate), and his vice president (or running mate) and his political aides read from a script that relies on the Laffer logic (Appendix I). They are the ones who make the policy if the candidate wins, not the academic economist.   George W. Bush had these same two top economic advisers in his first term, Hubbard and Mankiw, when he cut taxes and transmogrified a record surplus into a record deficit.

Trick 4, “Starve the Beast,” typically comes later, if and when the president is elected, has enacted his tax cuts, and discovers that smoke and mirrors don’t work against hard fiscal reality. He can’t find enough spending to cut (Magic Asterisk has disappeared up the conjurer’s sleeve); the acceleration in GDP is nowhere to be seen (Rosy Scenario has vanished in thin air); and tax revenues have not grown (no rabbit in the Laffer hat).   The audience is now told that losing tax revenue and widening the budget deficit was the plan all along.  The performer explains that the deficit is all the fault of Congress for not cutting spending and that the only way to tame the beast is raise the budget deficit because “Congress can’t spend money it doesn’t have.”  This trick never works either, of course.  Congress can in fact spend money it doesn’t have, especially if the “conservative” president has been quietly sending it budgets every year that call for that.   “Starve the Beast” as a budget strategy, like the other three, dates back to the first Reagan Administration. (Bartlett, 2007, p.6-7.)

By the time the crowd realizes it has been had, the confidence man has pulled off the greatest trick of all:  yet another audience who came to see the deficit shrunk instead leaves the theater with the deficit bigger than when it came in.

References
Bruce Bartlett, 2007, “‘Starve the Beast’ Origins and Development of a Budgetary Metaphor,”The Independent Review, XII, 1, summer, 5-26.
Jeffrey Frankel, 2008, “Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, September.
–2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications,” Oxford Review of Economic Policy vol.27, no. 4, 536-562. NBER WP 17239; Summary in NBER Digest.
David Stockman, 1986, The Triumph of Politics: Why the Reagan Revolution Failed (Harper & Row).
Murray Weidenbaum, 2005, Advising Reagan: Making Economic Policy, 1981-82 (Washington Univ., St.Louis).

[A version of this column appeared earlier at Project Syndicate, which has the copyright.  Comments can be posted there.]

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Will Republicans Really Block Tax Cuts Because They Go Only to Earners Below $250K?

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President Obama proposes allowing the Bush tax cuts to expire next year — as they are scheduled to do if nothing is changed — for those earning more than $250,000, but changing the law so as to extend the tax cuts for those earning less than that amount.   Republican politicians are opposing the proposal.    I don’t understand what they are thinking.  Their position doesn’t make sense to me, regardless whether they are thinking about short-term stimulus, long-term fiscal conservatism, good economics, or even pure politics.   

Start with the pure politics.   What is the end-game?   Are congressional Republicans prepared to block the Obama proposal extending the tax cuts for those making less than $250,000 and to let them expire as in the original legislation proposed by President Bush and passed by the Congress in 2001-03?   More than 95 % of Americans make less than $250,000.   Their taxes will go up on January 1 as a direct result if Republicans block the Obama proposal.  How are they going to explain their position to the voters when the current law takes effect?    Will it be: “To address budget deficits we need to let taxes go up on most Americans”?   That doesn’t sound like them.   Or: “Minimizing taxes for the rich is so important that we are willing to let taxes go up on everyone else”?     When it comes down to the wire, surely they would have to back down.  So why aren’t they thinking ahead?  

The same goes for the estate tax, which under the original Bush legislation is scheduled in January 2011 to bounce back from oblivion (beneficiaries of any rich people who die in 2010 don’t have to pay a dime of tax) to the old system of taxing estates worth over a million dollars at 45%.  The White House proposal is to exempt in future years all estates under $ 3 ½ million, $7 million for couples, and to tax only the largest estates.  If the Republicans are going to continue to oppose Obama, how are they going to explain this to the electorate?   That the only benefits that matter are those for the tiny minority of super-rich?

Now let’s move to economics.  If you were going after stimulus because the recovery is still weak, and if you believed that only tax cuts created stimulus, the priority should be in other areas like extending the Making Work Pay provisions for low-income workers, which are also set to expire.   This proposition holds regardless whether
(i) your idea of stimulus is Keynesian demand expansion (the lower-income workers have a higher marginal propensity to consume), OR even if
(ii) your idea of stimulus is purely enhanced incentives to work.  (Lower income workers face overall effective marginal tax rates that are often higher than the rich face, when one factors in payroll taxes, etc.)    Alec Phillips of GS US Global ECS Research points out that the amount of revenue (and stimulus) that is at stake in the expiration of Making Work Pay is greater than in the expiration of tax cuts for those over $250,000, and yet the latter question is getting all the attention and the former question is getting no attention.

Fixing the Alternative Minimum Tax is another sensible policy that qualifies as a tax cut relative to existing legislation, and should be part of any fiscal package.

If we want to achieve short-term fiscal stimulus from the viewpoint of good economics, then we should realize that well-chosen spending programs give far more bang-for-the-buck than most tax cuts.   (“Bang for the buck” means a high ratio of short-term fiscal stimulus to long-term damage to the national debt.  It’s the opposite of how the Bush fiscal program was designed in 2001-03.)    Examples of well-chosen spending programs include aid to the states (which Republican congressmen have been voting down) so that the hard-pressed states don’t have to lay off firemen, policemen, bus drivers, teachers and road workers.     Examples of tax cuts with much less bang for the buck include not just those for the rich (e.g., the abolition of the estate tax), but even garden-variety income tax cuts, because they are partly saved.    Don’t take my word for it.   Martin Feldstein (whose work on taxes and incentives led to the supply side revolution, and who was the Chairman of Reagan’s Council of Economic Advisers) argues that almost all of the income tax cut that was passed n response to the recession in 2008 was saved by households rather than spent, and predictably so, and that government spending would bring more short-term stimulus.

Of course good economics would mean not just short-term fiscal stimulus, but equal emphasis on measures to bring the budget deficit under control in the long run.   The best proposals are the least popular, as so often.   Fixing social security would be a huge step toward long-term fiscal responsibility, without endangering the current recovery.   A good package would combine all these measures. 

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