Now we find Berkeley Professor and former chairperson of the President's Council of Economic Advisors, Christian Romer, getting into the act. Her recent essay on the Times' opinion pages "Raising Taxes vs. Cutting Spending" takes to task Washington politicians and some in the media for latching on to an article she co-wrote with her husband as exhibit A for why tax increases are harmful for the economy. The article appeared in the American Economic Review and argues that the negative economic consequences from tax increases are even greater than conventional Keynesian thought indicates. I have even commented on the paper before.
Romer's thesis is that if we want to get the deficit under control, of our options--raising taxes, cutting spending, or both--"sensible tax increases will probably do less damage to economic growth and productivity than cuts in government investment."
It turns out that while she agrees tax increases are harmful in the short run, Romer thinks government spending cuts are even more harmful.The reason is a straightforward application of the Keynesian multpliier. Romer argues
There is a basic reason why government spending changes probably have a larger short-term impact than tax changes. When a household’s tax bill rises by, say, $100, that household typically pays for part of that increase by reducing its savings. Its spending tends to fall by less than $100. But when the government cuts spending by $100, overall demand goes down by that full amount.The moral of the story, for Romer, is a logical consequence of the above analysis:
. . . if federal policy makers do decide to reduce the deficit immediately, reducing spending alone would probably be the most damaging to the recovery. Raising taxes for the wealthy would be least likely to reduce overall demand and raise unemployment.
The fallacy in Romer's analysis is that she thinks the key to growing the economy is spending. In her mind, like that of John T. Harvey, recessions are do to insufficient aggregate demand, so the solution is for the government to make up for a lack of demand. That was the rationale behind the fiscal stimulus plans of both Presidents Bush and Obama. Such reasoning is also why Romer now claims that cutting government spending is worse than raising taxes.Now that the state's fiscal house needs to be at least partially put in order, Romer advises that the least painful way of doing it is to raise taxes.
This view entirely mistakes consumption for productive activity. Spending is just that--spending. In order for spending to be helpful, it must be true investment on productive activities. The only assurance we have that investment is productive is if it passes the profit/loss test. Government spending can never do that, because the state is not subject to the budget constraint. They do not have to make a profit to maintain their operations.
Christiana Romer also makes the mistake of treating government spending as "investment." Governments consume, they do not invest and produce.Even if they are directing spending toward "infrastructure" we have no reason to assume that such infrastructure work is indeed productive, in the sense that it benefits society more than it costs. In this case, governments direct money to projects they want built, not necessarily what the people who make up society want.
The reason why raising taxes is worse than cutting spending is that, even though the budget might be balanced by raising taxes, it still leaves too many economic resources in the hands of government bureaucrats. As I have written before, government spending actually consumes wealth by directing scarce factors of production away from their most productive uses. The taxing, borrowing, and inflating the state has to do to fund all of this extra spending all produce negative economic consequences. Such is the nature of reality. There is no way to spend our way to prosperity. The only thing the state has accomplished with its monetary and fiscal expansion is fewer goods available for higher prices.
The long-term solution, consequently, really is massive reducing the role of the state in our economy. Eliminating government programs and reducing business regulations. Such a policy would usher in true economic expansion as wise entrepreneurs would have the ability and incentive to invest capital paid for by real savings. Such economic progress results in more goods that can be purchased for lower prices.