The Fiscal Cliff and the Magical Solution

Both parties imagine a perpetual motion machine that creates wealth

by Frederick Saide, PhD.

Dr. Saide is founder and president of Foundation Insurance Services, LLC in Scotch Plains, NJ. He can be reached at [email protected]

Has anyone not heard of the “fiscal cliff?” Sometimes the “fiscal cliff” is referred to as “taxmaggedon.” Assuming that everyone following the impending national elections is paying attention, the public policy question of taxation, deficits, fiscal, and monetary policy somehow has managed to fly below the radar.
In January of next year, a whole range of tax reductions, credits and other breaks are set to expire. If this happens, the estimated total tax increase will amount to $536 billion based on estimates from the Tax Policy Center in Washington, DC.

A CNN Money survey of 17 top economists found that 14 believe without action by Congress and the White House to preserve the tax status quo the US economy will lurch back into recession. All 17 were confident that both parties will reach agreement before January 1, 2013 to prevent the massive tax increase. Both political parties engage in rabid partisanship. Thus far they have seen no reason to moderate their positions. The fundamental question is why?
By way of an answer, both political parties are dug-in on what makes the economy move. Both parties believe in their own separate versions of a perpetual motion machine which creates wealth in the national economy.

For Democrats, the magic machine is the Keynesian multiplier. Stated simply the multiplier holds for each $1 spent by the federal government, $3 to $4 is created in the economy thereby increasing and multiplying the velocity of money, or the circulation of money. Velocity is the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply and can be expressed as a number over time.

All empirical evidence about the Keynesian multiplier shows it has limited velocity, only $0.40 to $0.80 for each $1.00 spent. It is also true that the Democratic Party lacks true Keynesians because JM Keynes held in time of surplus the federal government should absorb excess resources and run a balanced budget and in time of scarcity the federal government should release resources by increasing spending and running deficits.

Democrats also argue that deficits do not matter. How they get to that position can be illustrated as follows. Suppose you were a doctor in the 18th or early 19th century and were called to treat an ill patient. The standard treatment was to bleed the patient. If the patient died the argument was not enough bleeding had occurred. It is the same for the Keynesian multiplier and deficits. If the economy fails to recover then the solution is more spending and higher deficits. Deficits do not matter due to the multiplier although all empirical evidence shows the multiplier is more fiction than fact no different than the doctor bleeding a patient.

The Republicans also have a perpetual motion machine called the Laffer curve and tax reduction. The Laffer curve is a representation of the relationship between government revenue raised by taxation and possible rates of taxation. It illustrates the concept of taxable income elasticity – that taxable income will change in response to changes in the rate of taxation. The Laffer curve usually postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100%. If both a 0% and 100% rate of taxation generate no revenue, but some intermediate tax rate generates some tax revenue, it follows that there must exist at least one rate where tax revenue would be a non-zero maximum.

However, politicians have learned that tax revenues returned to us as “free” benefits are what the electorate desires. So each party competes on how much they can provide us in benefits they are “fighting” to deliver to us.

The Laffer curve, the gospel of supply side economics, is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. The actual existence and shape of the curve is uncertain and disputed.

One potential result of the Laffer curve is that increasing tax rates beyond a certain point will be counterproductive for raising further tax revenue. A hypothetical Laffer curve for any given economy can only be estimated and such estimates are controversial. However, current estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%. In short two different tax rates can produce the same amount of revenue.

The Laffer curve is a shifting number because human behavior changes as tax rates change. That observation is accurate. There is some empirical evidence for the validity of the Laffer curve based on European research and additional research done for the World Bank on the German and Irish economies. There is also supporting empirical evidence from Eastern Europe and Hong Kong.
Tax-cut advocates should be careful not to over-state the revenue feedback caused by tax cuts — especially for tax cuts that are poorly designed (such as the Keynesian rebates and credits). But opponents of lower tax rates are equally misguided (or disingenuous) if they blindly assert that changes in tax policy never impact economic performance, and thus never cause revenues to rise or fall compared to static estimates.

Unfortunately, revenue estimating today is based on the absurd notion that tax policy does not affect macroeconomic performance. During 12 years of GOP rule in Congress, Republicans failed to modernize the revenue-estimating process at the Joint Committee on Taxation.

Since both political parties have an ideology which supports a version of a perpetual motion machine which constantly generates economic activity and tax revenue why compromise? Both parties have learned from constituents and contributors what is wanted are benefits provided by the federal government. It is always more spending on these benefits of various kinds which keep the two parties in political power and campaign contributions flowing. It does not matter if the benefits are paid for or not and add to the deficit. In fact by failing to pay for tax decreases and increased spending on benefits it can be argued that every major tax decrease such as the Bush rates provide the next tax increase. In other words all things staying constant, every tax decrease creates a deficit and eventually a tax increase.

However, politicians have learned that tax revenues returned to us as “free” benefits are what the electorate desires. So each party competes on how much they can provide us in benefits they are “fighting” to deliver to us.

Politicians will only reach a consensus on a solution at the 11th hour, as they have done previously on social security, when there are no other choices and they can exploit seeming reasonableness and bipartisanship. Until then do not expect to see any major changes because the differences between the Democrats and Republicans are present but are not as great as the media claims. The media needs to create a narrative about a presidential campaign and a horse race. Otherwise it would be more of the same boring politics which most people ignore to deal with the realities of their own lives.