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Krugman and Taxes

January 16, 2001Don Mathews

Tags Big GovernmentTaxes and SpendingFiscal TheoryOther Schools of Thought

The economy is slowing down rapidly, according to many government statistics and economic indicators. It’s slowing down so rapidly, in fact, that the likelihood of recession seems much higher now than it has in years.

Paul Krugman is worried. But the prospect of recession is not what has Krugman worried. "Recessions," he tells us in his December 27, 2000 New York Times column, "are not a serious problem for large, modern economies."

The reason for this good fortune is not that such economies are now immune from recessions -- they are not -- but that "recessionary tendencies can usually be effectively treated with cheap, over-the-counter medication: cut interest rates a couple of percentage points, provide plenty of liquidity, and call me in the morning."

No, what has Krugman worried is not recession but how certain politicians might respond to the threat of recession. Krugman writes, "Will they use a mild, easily treated ailment as an excuse to force expensive, dangerous quack remedies down the nation’s throat? I am, of course, talking about tax cuts -- which won’t cure the short-term slowdown, and will undermine our long-run fiscal health."

Krugman is right to be concerned about quack remedies prescribed by the government. But it’s not at all clear that he’s capable of identifying them.

While Krugman tells us that tax cuts are "dangerous quack remedies," he leaves us guessing as to why.

Perhaps he believes that tax cuts will ultimately lead to budget deficits, which will hurt the economy by "crowding out" productive activity in the private sector. Budget deficits do crowd out productive activity in the private sector. Government expenditures not financed by tax revenues must be financed by government debt, and when the government borrows, it extracts resources from the private sector.

But taxes extract resources from the private sector, too. How is it that budget deficits hurt the economy but taxes don’t?

And whose long-run fiscal health is Krugman concerned about, the government’s or the private sector’s?

Or perhaps Krugman objects to the government’s use of taxes as a tool of demand management, a tool of countercyclical fiscal policy. After all, even if the Keynesian view of the world is correct -- an extremely dubious proposition -- the pitfalls of countercyclical tax policy are insurmountable.

Tax rate changes have lagged effects that are too unpredictable for countercyclical tax policy to be administered effectively. And because it is politicians who set taxes, decisions on taxes are subject to the usual unsavory political machinations, all of which render the effective administration of countercyclical tax policy a pipe dream at best.

But if that’s why Krugman objects to tax cuts, why does he advocate using money as a tool of demand management?

The theory behind using money as a tool of demand management is Keynesian theory. It asserts that the central bank can stabilize the economy by engineering easy money when the economy is slumping and tight money when it is booming. Easy money in a slump will stimulate demand and prevent recession; tight money in a boom will curtail demand and prevent inflation -- so the theory goes.

But Keynesian theory is the very theory Krugman rejects when it comes to using taxes as a tool of demand management. And, as Krugman readily admits, countercyclical monetary policy suffers from the same sort of unpredictable, lagged effects that countercyclical fiscal policy does.

Krugman claims "experience suggests that the Fed can almost always persuade consumers and businesses to spend more by cutting interest rates" -- that is, by administering an easy monetary policy. But countercyclical monetary policy of any sort is not the "cheap, over-the-counter medication" Krugman says it is.

To use Krugman’s medical metaphor, the trouble with countercyclical policy is the correct doses of tight or easy money are unknown, and the wrong doses transform an otherwise stable economy into a manic-depressive one. And what experience actually shows is, when the central bank attempts to play doctor, it routinely makes the economy sick.

The current macroeconomic predicament is a case in point. The U.S. economy is slumping now because, for the past year and a half, the central bank has been administering a tight monetary policy to remedy what it perceived to be a possible inflationary boom. But the boom was caused by an excess dose of easy money the central bank administered in previous years. The Fed was the silent partner in the explosive dot com runup.

The path of the boom was unusual but the current slump is anything but unique. The U.S. economy has been through four recessions over the past three decades. Each one was largely if not entirely the result of the central bank administering tight money to remedy a previously administered excess dose of easy money.

But the real warp in Krugman’s perspective is more fundamental than his view on monetary policy. Krugman’s perspective is the perspective of the government planner. He sees the economy as akin to a patient, government officials and their accomplices in the intellectual set as akin to doctors, and government policies as akin to remedies.

The perspective -- and the metaphor -- are all wrong. The economy is not akin to a patient, government planners and their intellectual accomplices are not akin to doctors, and government plans are in no way akin to remedies.

What should be done about the current economic slowdown? What’s needed is for central bank officials and other government planners to stop trying to play doctor with the economy. The economy is a healthy organism that can take care of itself.

Taxes should be cut, but not for the purposes of demand management. Nor should taxes be cut to stimulate supply -- though tax cuts will, over time, increase supply by increasing the return to productive endeavors.

Taxes should be cut because they are currently far above any level that is consistent with liberty, which is the precondition for prosperity.

But liberty would appear to be the farthest thing from Krugman’s mind. How else to explain Krugman’s worry that "expensive, dangerous quack remedies" -- tax cuts -- might be "force[d] down the nation’s throat"?

The only throats that tax cuts have to be forced down are the throats of government planners, for only government planners find tax cuts expensive.


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