Some time in February, Congress will have passed and the President will have signed an economic stimulus package, a bill ostensibly intended to jump start a weakening U.S. economy. Many economists, including me, thought that the economic malaise of the 1970s had laid to rest U.S. adherence to Keynesian economics with its fundamental reliance on government spending as a tool to boost a lethargic economy. Even if such spending were effective, by the time Congress slices, dices, and delays any bill, the negatives will outweigh the positives.
First, it is a dubious proposition that a mere $150 billion, approximately one percent of the nation’s yearly output, dumped into the hands of low to middle income taxpayers will have the intended impact. Nobel laureate Milton Friedman advanced and empirically validated the idea that consumers spend based on permanent income, not transitory income flowing from any financial windfall, including government largesse. Accordingly, with credit card debt growing by more than seven percent over the past year, it is likely that a high proportion of the rebates will be used to pay down these balances rather than spent on goods and services.
Second, inflationary pressures in the U.S. economy for 2007 grew to their highest levels since 1990. To the degree that the stimulus package does have an impact on consumer spending, it will tend to advance inflationary pressures. Thus, the Federal Reserve rate setting board will be less aggressive in cutting interest rates to pump up the economy since such a reduction would fuel even higher inflation. That is, the benefits of the stimulus package, in the unlikely event that it does expand spending, will be offset by higher interest rates from the Federal Reserve.
Third, the federal budget deficit for the latest fiscal year will approach $200 billion. Increasing the size of this deficit with a stimulus package will add to the nation’s debt just at the time when austerity is demanded. In 2008, the oldest of the nation’s “baby boomers” will qualify for social security retirement benefits. Over the course of the next 18 years, the number of retirees receiving social security benefits will expand at rates not seen since the program was launched by President Roosevelt in the middle of the Great Depression. A questionable stimulus program will only exacerbate this problem.
Fourth, the stimulus package will further shift the burden of funding federal spending to higher income individuals, diminishing their willingness to engage in productive work behavior. As the package currently stands, families making more than $175,000 yearly will not receive “rebate” checks from the federal bureaucracy. In 1981, the first year of the Reagan Presidency, the top 1.0 percent of income earners paid 17.6 percent of federal taxes. In 2005 after the often labeled “unfair” Reagan and Bush tax cuts, the top one percent of wage earners paid 39.4 percent of all federal taxes. Unfortunately for tax collections, the top earners, as compared to low income recipients, also possess greater ability to cut back on their work effort. For example, physicians can, in many cases, increase their leisure by reducing the hours that they work per week. Thus, increasing the relative tax burden for high income workers inflicts a dual economic hurdle of reducing federal tax collections at the same time that it undermines higher income individuals’ support for a system that places them in the tax bulls-eye. Of course there is the political benefit for Congress of shifting the burden of funding the federal government from the 99 percent of citizens who are taxed at relatively low rates to the one percent who are taxed at high rates.
So what should Congress and the President do to provide a bounce to a waning U.S. economy? They should extend the Bush tax cuts of 2001 and 2003. Rather than a short-term band-aid, this will serve as a needed long-term positive structural change. It is certainly plausible that the current downward spiral in the stock market has been the result of investors expecting a win by either Clinton or Obama in the November Presidential elections. Each has either signaled or explicitly stated his or her intent to raise tax rates on dividends and capital gains when the Bush tax cuts expire in 2010. Such a large tax increase on the horizon has been a factor pushing stocks lower over the past several months. That is, rational investors are looking ahead to soaring taxes on stock gains from tax-and-spend political leaders. As I have stated in an earlier essay, such policies make good politics but lousy economics.