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Tax cuts versus government spending

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When the national government intervenes in the economy to fight recessions, it has two fiscal policy tools at its disposal: tax policy and government spending. These tools arise from policy prescriptions of British economist John Maynard Keynes, who in the 1930s in his book General Theory of Employment, Interest and Money proposed that government should use its powers to tax and spend to take an active role in fighting recessions and inflation.

According to Keynes, the government should increase spending and cut taxes during recessions to stimulate the economy. In good economic times, they should increase taxes and cut spending to pay off the deficits incurred during tough economic times and to fight inflation. So instead of balancing the budget over a single fiscal year, the budget is balanced over the course of the business cycle.

The recent debate'in Washington regarding fiscal policy has been over the appropriate mix of tax cuts and government spending. Those on the right tend to favor tax cuts, while those on the left favor increased government spending.

The argument for tax cuts is based on both supply - and demand-side economics. On the supply side, reduced business taxes provide an incentive for expanded production. If business expansion is made less expensive through lower taxes, more of it will be untaken. This would create jobs in commercial construction, machinery and technology production, and within the businesses themselves since expansion means increased production, which means more workers typically are needed.

On the demand side, lower taxes for households help spur consumer spending, since workers get to keep more of their earnings in take-home pay. When consumers buy more, production must be expanded to meet the increased demand, which means more jobs. Jobs are also created as goods are transported and sold.

While tax cuts have both a supply - and demand-side component, increased government spending to stimulate the economy tends to focus exclusively on the demand side, notwithstanding that increased demand would logically be followed by increased supply. Government spending increases the demand for goods and services, and meeting this demand creates jobs in the sectors that provide these goods and services.

The argument over which approach is more appropriate goes back many decades. Those who prefer tax cuts argue that it takes advantage of the benefits of the free market system by allowing individual consumers to decide what and how much will be produced. Government spending, on the other hand, places these decisions in the hands of government. This argument parallels the arguments of the virtues of the free market, in which consumers decide what and how much will be produced, over those of the command or communist economic system, in which government decides.

Those who prefer increased government spending as a means of stimulating the economy argue that tax cuts might not go far enough, especially during times of deep recession. The concern reflects the old adage that you can lead a horse to water but you can't make it drink. If workers keep more of their earnings in take-home pay, they may simply hoard the money as a safety net in case economic times worsen. Or they may use it to pay down debt, which is probably underrated as a means of stimulating the economy. Lower levels of consumer debt would likely go far in restoring consumer confidence and stimulating future economic growth, though the lag between paying down debt and future levels of spending might not address immediate job-creation concerns.

With the depth and breadth of the recent recession and the continued slow recovery, there are strong arguments for both tax cuts and increased government spending. There is, of course, plenty of room for debate on where the increased spending and tax cuts should be targeted.

One of the main criticisms of government fiscal-stimulus spending is not necessarily how much is being spent, but rather where the funds are being spent. Responsible stimulus spending is targeted toward infrastructure improvements that would be necessary and proper regardless of economic conditions. Thus, economic conditions should not tell us what to spend on, but rather when. There are strong arguments' that pet projects and spending that would not occur otherwise, save for an economic downturn, are wasteful.

Looking ahead, one of the biggest challenges will be turning off the fiscal stimulus once economic conditions warrant. This includes implementing the other side of the Keynesian prescription: cutting spending and raising taxes during good economic times to pay off the deficits incurred during bad times. Historically, this has been a challenge for policymakers.

Keynes has, at times, gotten bad rap from some economists for promoting government intervention in the economy. But to be fair, it's more the lopsided implementation of Keynesian prescriptions that have warranted scorn. Expansionary policies of increasing spending and cutting taxes are politically popular and quickly undertaken during downturns. Raising taxes and cutting spending to pay off the deficits when conditions improve are much less popular and often neglected. This unbalanced approach to Keynesian economics has contributed to persistent deficits and an increasing



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© 2011 Arizona Range News Willcox, Arizona. All Rights Reserved. This content, including derivations, may not be stored or distributed in any manner, disseminated, published, broadcast, rewritten or reproduced without express, written consent from DAS.

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