OverLeveraged — A Blog About Debt

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Tax Cuts Erroneously Key Topic Of Fiscal Cliff Debate

The debate in Washington is as ongoing as it is intense. The only issue is that they are debating the wrong thing.

Student-Loan-Fiscal-Cliff

Current status of the negotiations regarding the so-called fiscal cliff? Ongoing with no indication of a near-end resolve. Yesterday’s status of the negotiations? Same. Tomorrow’s? Take a guess.

The debate comes off as about an interesting topic to cover as reporting on the weather in Indonesia during monsoon season. However, there is one interesting angle that has not been awarded even close to the attention it deserves – how ideological differences largely overshadow the economic realities of government policies.

The cliff has two components to it: spending cuts and tax increases. The latter is unarguably receiving most of the attention and seemingly the one being the most vigorously debated on, largely due to the fact that it represents one of the most deeply rooted differences between the ideologies of the elephants and the donkeys. The fact that the discussion mostly circulates around whether the increases should be put on the rich to the favor of the less fortunate makes it a thankful topic to report on – sort of a tax code-ish David versus Goliath.

However, little light is shed on the fact that governmental spending has a greater effect on the overall economy during downturns than do individual tax cuts.

The underlying theory is that of the money multiplier: that each dollar spent in the economy by an exogenous source increases spending by a multiple of that increase. If the government builds a bridge, it pays a contractor to do so; the contractor pays his suppliers; the suppliers pay their employees; the employees go home and buy food and clothes for their families; the money goes to the store owners who in return purchase more inventory from their suppliers, and so on, generating a spiral of spending.

The theory was developed by Richard Kahn in 1931 and became one of the key provisions in the framework for economic theory attributed to John Maynard Keynes.

Tax cuts are less likely to lift an economy than government spending since consumers may end up saving most of the additional money, particularly in times of widespread uncertainty that is largely prevalent during economic downturns, whereas fiscal stimulus goes straight into the economy in form of spending.

Support for the argument has been found by three economists of the International Monetary Fund, reporting on their findings in Fiscal Multipliers and the State of the Economy.

It is therefore fascinating to see how skewed the current debate in Washington is. It is yet another testament to how political goals overshadow economic realities, because after all, effects from across-the-board spending cuts in governmental agencies will be seen gradually and directly affect only a small fraction of the population compared with rising tax rates that each American will be able to see directly when being handed their paychecks in January.

But then, most senators are lawyers, not economists.

On a different note –  Bloomberg News finally seems to have caught up on the obvious.

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2 comments on “Tax Cuts Erroneously Key Topic Of Fiscal Cliff Debate

  1. Tobias Härnvi
    December 7, 2012

    Interesting. And the tax money that the rich people get to keep is likely saved whereas subsidies or grants for the poorer part of the population is consumed and therefore a contributor to this money multiplier.

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This entry was posted on December 7, 2012 by .
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