Wednesday, February 11, 2009

How Tax Cuts Could Backfire

For a little light on the hot topic of the day, the final shape of the stimulus bill, here is an expert view under the title of "Can Tax Cuts Deepen the Recession?"

A new paper by Gauti Eggertsson of the New York Fed argues that tax cuts will lead to increases in both supply and demand, failing to close the gap between the two.

"Under normal circumstances," notes the Times' Freakonomics blog, "this doesn’t present a problem, because the Fed can lower interest rates to close this output gap. But right now, the Fed has set interest rates as low as they can go, and so different principles apply. Eggertsson’s concern is that a big output gap will lead inflation to fall, leading real interest rates to rise in the middle of the recession.

"These higher real interest rates further dampen economic activity, and with the Fed powerless to offset this, there’s the very real risk of a deflationary spiral. And so a tax-cut-based fiscal stimulus might actually backfire. In fact, Eggertsson reckons there’s a chance that tax cuts could even deepen the recession."

As Republicans keep repeating their mantra of putting money into the taxpayers' pockets, Democratic negotiators might try to slip some rational arguments into the discussion. Eggertsson's theory has no historical data to validate it, but it seems to make sense--if that has any place in the deliberations.

1 comment:

(O)CT(O)PUS said...

In a blog post called, The Ghost of Depression Past, I argue that the current crisis is a replay of the Great Depression when wealth was concentrated into the hands of the few:

In essence, Bush's economic policies created conditions similar to those that triggered the Great Depression. From 2001 through 2007, the American economy grew by 31%, but the increase in wealth was not fairly or evenly distributed throughout the economy. After-tax income for corporate CEOs grew … whereas average income for middle class wage earners declined …

Factoring in rising costs of energy, food, education, and health care, which rose faster than the base inflationary rate, what do you get? A middle class that can no longer serve as the engine for economic recovery. Thus, the real reason behind our economic crisis is the concentration of wealth in the hands of the few at the expense of the many ... just like it was almost 80 years ago.

Eggertson’s argument seems a bit weak, perhaps even contradictory. In an uncertain economy, where producers and consumers are motivated to be cautious in equal measure, aggregate supply may not necessarily increase in response to aggregate demand as consumers keep their tax cuts. In any event, please have a look and feel free to join the discussion.