Increase Taxes or Cut Spending: Oregon’s Bleak Choice

By my count, and I could be wrong, 36 Oregon economist signed a letter supporting the Legislature’s tax increases in response to the State’s budget problem. These are the key paragraphs:

“ Cutting state spending reduces in-state aggregate demand, virtually dollar-for-dollar. Some forms of state spending, particularly in the area of health care, bring matching federal dollars into the state’s economy. So cuts to certain public services result in even bigger reductions in aggregate demand because they prevent federal dollars from coming into Oregon’s economy.

Tax increases targeted at high-income households and corporations also reduce demand, but not as much as cutting state services. High-income people typically don’t spend all their money, and some of the money that they do spend is likely to be spent outside Oregon. In addition, the deductibility of state income taxes from federal taxable income means that a fraction of state tax liabilities are, in effect, shifted to the federal government. Therefore, a tax increase on high-income Oregonians does not reduce aggregate demand in Oregon dollar for dollar. And since a significant fraction of Oregon’s corporate taxes are paid by out-of-state, multi-state corporations, the corporate tax measure also does not reduce demand dollar for dollar in Oregon.”

This is the tired old Keynesian argument that the government spending multiplier is larger than the tax multiplier. It comes from the Keynesian Cross, an unfortunate construct that has led to lots of bad policy.

Mankiw, a New Keynesian, discussed the debate in a NYTimes article last January. Here are his key paragraphs:

“MIGHT TAX CUTS BE MORE POTENT? Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”

I’d put my money on the evidence. Keynesian theory is appealing. It offers a free lunch. Unfortunately, free lunches are hard to find in the real world.

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