Tax Cuts vs. Government Spending

If politicians in Washington want to avert the fiscal cliff and have a chance of keeping their jobs, a resolution will be struck sometime tomorrow, likely late in the day.  After devising a possibly very destructive strategy, which entailed backing themselves into a corner, the denizens of DC are in a position in which they must do what appears to be politically destructive: agree! 

In aggregate, the country chides Washington for failing to work together. But many politicians fear that pleasing the general population by working together would ostracize their constituency and endanger them in their own district—a catch 22 that should encourage us to start thinking about term limits for all members of congress. Everyone is pulling their punches, conserving their energy for the next big fight. We’d get more out of them if we encouraged stirring sprints over monotonous marathons.

Aside from political maneuvering, what ideological differences are at the heart of the fiscal cliff stalemate? That question frequently yields a common answer: taxes vs. government spending. In general, the Republicans seem to believe that slashing government spending and cutting taxes is the best remedy for stimulating the economy while narrowing our deficit. They contend that a lower marginal tax rate incentivizes entrepreneurship and innovation, whereas higher taxes bleed the ambition of potential job creators. Government spending, say the Republicans, is often wasteful and succeeds only in crowding out private enterprise. On the other side of the aisle, Democrats believe that government spending is a more effective fiscal policy for stimulating the economy, and that a marginal tax hike—on those who can afford it—is a responsible measure to curb our deficit, and will have a negligible effect on entrepreneurship.

As a rookie economist, what I do not understand is the logic behind the right’s fiscal policy argument, espousing tax cuts while tempering government expenditure. Economics 101 tells us that when the economy is stuck in a recessionary gap, the government may invoke fiscal policy to shore up aggregate demand, which leads to more goods and services being purchased at any given price level. It would look a lot like this:

The question on the table is: Is it better to use tax cuts or government spending to increase aggregate demand? Many on the left, and it seems most economists, say government spending is more effective. Most on the right claim that tax cuts are more effective. My confusion with the right-wing economic ideology arises when we consider the multiplier effect of fiscal stimulus.

An increase in goods and services purchased by the government tends to lead to an even greater increase in the total goods and services purchased by the aggregate economy. If the government increases its spending by $10 billion, the total effect on aggregate demand will be even greater, depending on the marginal propensity to consume. If consumers spend two thirds of each extra dollar of disposable income they receive, then the marginal propensity to consume is 66.7%. Operating under this assumption, the total effect of the government’s $10 billion expenditure will be $30 billion:

1/(1-MPC) = multiplier

1/(1-.667) = 3

$10b x 3 = $30b  

For example, if the government pays a defense contractor $10 billion to supply tanks, the defense contractor may in turn spend 2/3 of that income (our MPC) buying new computer equipment from a computer manufacturer. The computer manufacturer may then spend 2/3 of his income on labor. A new hire may then spend a proportion of her income on a home remodel. The contractor for the home remodel may in turn spend some of his additional income on a new car. The lucky car dealer may spend a fraction of his new income at the corner store… If the MPC is 66.7%, the ripple effect throughout the economy would look something like this:

The $10 billion in government spending results in a $30 billion increase in the purchase of goods and services in the economy.

Alternatively, if the government decided instead to give $10 billion in tax cuts, the initial boost in aggregate demand would not be $10 billion, but $6.67 billion. This is because households and businesses would save 1/3 of each additional dollar earned (their marginal propensity to save). The multiplier would work the same way, but it would be less significant. Instead of a $30 billion total increase in the purchases of goods and services, the increase would only be $20, which we get by multiplying our initial boost to aggregate demand by our multiplier ($6.67b x 3 = $20.01b).

So why, then, do conservatives advocate tax cuts, but dismiss government spending? Is it to allow private enterprise to decide where capital flows? With deficit spending at an alarming rate and the economy still depressed, what is the right balance for fiscal stimulus? How do we shore up the economy without generating deficits that will compromise our future? Given that government spending has a greater effect on aggregate demand, it seems like we should raise taxes to increase revenue while honing government spending. Specifically, it seems like we should raise taxes on consumers with a lower marginal propensity to spend. For each extra dollar of income, who is more likely to spend it: the single mother making $30,000 per year and spending all of her disposable income, or the CEO of Wal-Mart, who would be hard pressed to spend the majority of his income?

Of course, these broader questions lead to an unsavory break out of more specific questions. Would the wealthy spread their delicate wings and flutter away if their marginal tax rates increased by 6%? And if this did happen, who on earth would create jobs! After all, it is the wealthy who create them jobs. Can anyone name a single person from the middle class who started a viable business that employed other people? (Hint, this guy, this guy, this guy).

The GOP propaganda machine (cough cough) has propagated a divisive and contorted version of reality. They have managed to paint tax increases, of any magnitude, as class warfare—punishing the wealthy for having made it. But the grown-ups out there know that our economy is weak and in peril. We’re faced with the unenviable task of jump starting the world’s biggest economy, while simultaneously curbing our deficit. Marginal tax hikes on the 1% are not meant to punish the rich who, in most cases, have worked hard to achieve their net worth and do employee people. But from a cold, depersonalized approach, which fiscal policy measure gives us the most bang for our buck(s)?