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Not The Pundit’s Package
Bush did an end-around on the Keynesians.


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It is amazing how little the pundits understand President Bush’s economic views.

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Just a few days ago editorials referring to the Bush economic plan were speculating as to what the plan would and would not include. The editorials were almost in unanimous agreement that the president would have to “soften” his stimulus package. The softening options included paring back the planned elimination of the double taxation of dividends to 50%. Another possibility was to drop the plan to accelerate marginal rate cuts for higher earners. .

Yet to the surprise — and perhaps disappointment — of many pundits, the president went beyond what was originally expected. He proposed a larger program, with deeper cuts focused on individual rate cuts.

How could the pundits have it so wrong? They were using a Keynesian framework instead of a supply-side framework.

Within the textbook Keynesian model government spending and tax revenues are two sides of the same coin. One increases aggregate demand and the other reduces it. Hence, reductions in spending and/or revenue enhancements are equally attractive ways to reduce the deficit. The revenue impact of the tax is all that is needed to determine its impact on the economy through its aggregate-demand effects. It doesn’t matter whether the tax rate is temporary or permanent — only the magnitude matters.

This is quite important. If no allowance is made for the disincentive effect of higher tax rates, the effect of the rate change on the tax base is assumed to be nonexistent. That’s a static revenue estimate.

The simple Keynesian framework also does not take into account government budget constraints. Deficit financing implies future tax liabilities; a forward-looking taxpayer would anticipate the future taxes and that would negate the aggregate-demand effects that the Keynesian claims the deficit financing generates.

Supply-siders counter that there is no income effect once one takes into account the government budget constraint. All that remain are the substitution effects, or incentive effects, that the Keynesians ignore.

Unlike the Keynesians — who focus almost exclusively on the income effect of the tax cuts — the president focused on the incentives that his program would generate. Regarding the budget deficit he argued that what we have is a temporary revenue shortfall. He also offered a solution to the problem: growth, not higher taxes. While remaining true to his argument for a smaller government, he argued the need for (hopefully) temporary higher spending. And on the role of government, he was crystal clear:

Government spends a lot of money, but it doesn’t build factories, it doesn’t invest in companies, or do the work that makes the economy go. The role of government is not to manage or control the economy from Washington, D.C., but to remove obstacles standing in the way for faster economic growth. That’s our role.

Bush also understands the disincentive effects of higher tax rates and higher regulation:

Many jobs are lost in America because government imposes unreasonable regulations, and many jobs are lost because the lawsuit culture of this country imposes unreasonable costs. . . . I will continue to press for legal and regulatory reform. But today — today I want to talk about these concerns: Americans carry a heavy burden of taxes and debt that could slow consumer spending. I’m troubled by that. I’m also troubled by the fact that our tax system unfairly penalizes some productive investments.

If that is not focusing on incentives, what is? The case for lower tax rates was clear in the president’s mind. In order to avoid a slowdown generated by the transition effects of prospective rate cuts, Bush asked for the cuts to be enacted retroactively to the beginning of the year:

If tax relief is good enough for Americans three years from now, it is good enough for Americans today.

Indeed, the president sees no need for uncertainty about taxes:

Americans should be able to count on those tax cuts as they plan their financial futures. So I will continue to press the Congress to make these cuts, including the end of the death tax, permanent. We know that tax cuts [work], and Americans deserve to know their cuts will not be taken away.

Finally, in summarizing his economic package, George W. Bush correctly focused on growth and incentives rather than income and redistribution:

This growth and jobs package is essential in the short run; it’s an immediate boost to the economy. And these proposals will help stimulate investment and put more people back to work. . . . They are essential for the long run, as well — to lay the groundwork for future growth and future prosperity. That growth will bring the added benefit of higher revenues for the government — revenues that will keep tax rates low, while fulfilling key obligations and protecting programs such as Medicare and Social Security.

Spoken like a true supply-sider, Mr. President.



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