Tuesday, July 27, 2010

How Politicians Bring Down Deficits: Geithner vs. Romer and Perhaps Romer vs. Romer

It's not by reducing government spending--the one thing that would actually help the economy. Instead, Tim Geithner, Secetary of the Treasury, says we should raise taxes by letting the Bush tax cuts die for two reasons:

  1. It will not push us into a new recession.
  2. It will show a commitment to cutting the deficit.
It's not clear to me that we are entirely out of the "old recession" yet. Even if we are, however, Geithner's second reason belies ignorance of the truly significant factor affecting economic prosperity. An astronomical government debt is not the main evil, per se. It is what it represents, a massive increase in spending above what is taken in as tax revenue.

There are two ways to reduce the government deficit, one is helpful to the economy and the other is not. If the government raises taxes, the government deficit may indeed be reduced, but this does not remove the drag on the economy. It merely shifts the funding of the state apparatus away from borrowing and toward taxation. Both taxation and government borrowing, however, draw resources out the private economy and result in capital consumption. Capital consumption is a recipe for economic contraction. With less capital profitably invested, labor productivity falls, putting downward pressure on wages and incomes, lowering our standard of living.

Randall Holcombe notes that an empirical study co-authored by Christina Romer, head of President Obama's Council of Economic Advisors, verifies the contractionary nature of taxation. Her paper, "The Macroeconomic Effects of Taxation," was published in the June 2010 American Economic Review and concludes that "tax increases are highly contractionary." A pre-publication working-paper version can be found here.

One interesting finding by Romer and Romer is "that tax increases designed to reduce a persistent budget deficit appear to have much smaller output costs than other exogenous tax increases." This makes sense, because of the reasons mentioned above. Raising taxes to decrease a budget deficit is merely shifting sources of funding. Capital consumption that is already occurring due to government borrowing will merely continue due to taxation, so the negative effects of taxation in this case will not appear to be as drastic a change. Note, however, that the effect is still negative. Thus economic history contradicts Geitner's hope that increasing taxes will not be a drag on the economy. It will also be interesting to see, as Holcombe asks, will Romer the political appointee listen to Romer the economist?

If Geithner and company want to point us in the direction of prosperity by way of reducing the deficit, their only option is to reduce government spending. Reducing spending will allow for less government borrowing and lower taxes. Both will keep more capital in the hands of capitalists and entrepreneurs who will invest it in productive activity instead of government consumption. Focusing on the deficit per se distracts us from government spending, the real enemy of prosperity.

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