Why This Stimulus Package Won't Work — And What Will

There was a very good editorial in the Wall Street Journal yesterday on the current stimulus package heading through congress and why it won’t work.

Here are a few of the key reasons that it won’t work, some of which are covered in the article and some of which are not:

Public Works Projects Do Not Stimulate the Economy

The government has to fund those projects by taking the money from somewhere else (through taxes or borrowing). Thinking that public works will stimulate the economy assumes that the government will invest that money more productively than the private sector would. But that is almost never true.

Plus, the government is not our parent. It should not try to take care of us by stepping in to create jobs directly. It’s aim should be to keep us — the citizens in the private sector — maximally free to act. Let’s learn from the 1930s!

Government Spending Does Not Stimulate the Economy

This is really another way of stating point one. It is not spending per se that stimulates the economy. It is spending on profitable ventures which advances the economy. The private sector has a litmus test for knowing what society needs and wants most: profit and loss. But the government has no such means of knowing what is truly most wanted and needed.

I know that profit and loss realities alone do not create a good society — we must also have non-profit enterprises, and yes government does have a legitimate role. But the point is that, in the governmental realm, the incentives are not there to direct government spending toward the specific “stimulus projects” that society truly needs. So it needs to keep such initiatives to a minimum.

The business sector, on the other hand, has a clear test governing how it invests: the ventures that a business invests in must be profitable. But this is not so with government initiatives, since they are funded not by business results (profits) but taxes. And those taxes take money away from businesses and individuals — that is, they take it away from those that invest according to the clear and decisive knowledge of profit and loss.

The Problem is Lack of Supply, Not Lack of Demand

During the depression, FDR and his administration kept trying to figure out ways to stimulate demand. That has it backwards. The problem is never lack of demand — human demand is basically infinite.

The problem is that, when it comes to the economy, you first have to produce before you can receive. My family needs a larger vehicle right now. The want, need, and “demand” are there. Here’s what is not there: the money (or, at least, an amount that would leave us with the savings level we want after the purchase). I need to figure out how to produce the equivalent value of a vehicle before I can actually go buy that vehicle. (Or, alternatively, I need to be confident enough in the economy to take out a loan and trust that my future earnings will be sufficient to pay that off.)

So nobody needs to convince me or anybody else to want various goods and services. The issue is that we need to be able to produce enough in order to purchase them. In other words, supply creates demand. If we define “demand” as the actual decision to purchase a vehicle, rather than simply the desire for one, we see that that kind of demand is created by supply — that is, by my producing something of value, which value I can then “exchange” for the vehicle.

The Solution is Immediate and Permanent Tax Cuts

If the problem is lack of supply, then the solution is not to stimulate demand, but to stimulate supply. Or, if we want to put it another way, the way to stimulate demand (defined as the actual decision to buy) is by stimulating supply.

So how do you stimulate supply? Well, you don’t really need to stimulate that, either. It is a part of human nature to seek to be productive. We have an ongoing thirst to create, make things, and produce. That is a good thing.

The problem is that there are obstacles that interfere with this. Sometimes the obstacles are simply that life is hard. But most of the time, the biggest obstacles are created by the government — unintentionally, of course, and usually in the name of “stimulating the economy” or “making things equitable” and such. What needs to happen is simple: these obstacles that we can control, namely those created by the government, need to be removed. The government has to “back up” a bit.

And that means tax cuts. Taxes are legitimate and necessary. But high taxes are the biggest obstacle to the ability of people and business to produce (excessive regulation is a close second). This is because taxation diverts money away from private sector investment in productive goods and services and into government initiatives. In other words, there is less money for businesses to invest in creating and expanding their goods and services.

There is objective, real-world evidence that tax cuts do indeed lead to a growing economy. We saw this with the Kennedy tax cuts of 1964 and Reagan tax cuts of 1983, for example. Further, the WSJ piece notes that “Research by Mr. Obama’s own White House chief economist, Christina Romer, has shown that every $1 in tax cuts can increase output by as much as $3.” This is in contrast even to the best-case scenario thinking behind the government spending approach to stimulating the economy, which is based on a theory that “each $1 of spending the government ‘injects’ into the economy yields 1.5 times greater output.”

Even if that theory were true, that is still only half of the stimulus created by tax cuts. But, more importantly, it’s not true. As the WSJ piece also notes, “There’s little evidence to support this theory [that $1 of government spending creates $1.50 in output], but you have to admire its beauty because it assumes the government can create wealth out of thin air. If it were true, the government should spend $10 trillion and we’d all live in paradise.”

Again, there do need to be taxes. But a 35% corporate tax rate and 35% individual tax rate for top earners is far beyond what the founders would have envisioned (in fact, we did not even have an income tax for the first several generations in our nation’s history). We are in absolutely no danger of taxing businesses to little. There is a lot of room for taxes to come down, in turn resulting in greater economic growth.

Some object that this is not a true picture of the corporate tax burden because many transfer their money to tax shelters (for example, see this article at Smart Money). But that is precisely part of the problem as well: corporations and individuals end up moving portions of their income to less productive tax shelters, which thus also diverts money away from more productive uses. It is ironic that you even see this done by wealthy individuals that espouse the “need” for higher taxes — they call for higher taxes, while at the same time seeking to minimize their own tax burden through various tax shelters.

Let’s affirm that is a good thing, not a bad thing, that people want to minimize their tax burden. Of course most people want to minimize the taxes they pay. We try to minimize the amount we have to pay for everything – we never want to pay more than we have to, whether at the grocery store, Target, or anywhere. That’s part of the reality of living in a world of finite resources, and it is a good thing.

The really incredible thing is that reducing taxes not only syncs with the good and natural human desire to see as little of our income as possible removed from us through taxation, but also frees up people and businesses to more fully invest in productive initiatives, thus expanding the economy.

But the tax cuts need to be permanent, because otherwise they cannot lead to a permanent change in behavior. Further, they need to be immediate and “on the margin”:

To be genuinely stimulating, tax cuts need to be immediate, permanent and on the “margin,” meaning that they apply to the next dollar of income that an individual or business earns. This was the principle behind the Kennedy tax cuts of 1964, as well as the Reagan tax cuts of 1981, which finally took full effect on January 1, 1983.

If the Obama Democrats can’t abide this because it’s a “tax cut for the rich,” as an alternative they could slash the corporate tax to spur business incentives. The revenue cost of eliminating the corporate tax wouldn’t be any more than their proposed $355 billion in new spending, and we guarantee its “multiplier” effects on growth would be far greater. Research by Mr. Obama’s own White House chief economist, Christina Romer, has shown that every $1 in tax cuts can increase output by as much as $3.

This is not hard. Obama could solve this recession in a day. Propose a tax cut bill that cuts taxes immediately, permanently, and “on the margin;” shepherd its approval through Congress (which is controlled by his same party), and then the day that he signs it into law, the recession will be solved. The effects would take many months to be felt, for sure. And the bad loans do need to clear out as well. So I’m not saying the recession would end that same day. But the healing would begin immediately, and would lead to a true and lasting recovery via the quickest route possible.

January 27, 2009 | Filed Under Economics | 8 Comments 

Comments

  • http://fireandknowledge.org Josh S

    “Obama could solve this recession in a day.”

    Maybe I’m the odd one out, but that sounds a tad unrealistic to me.

    :)

  • Pingback: Quick, Read This! « To Be A Pilgrim

  • reboot

    Unfortunately, fixing the recession on paper, which is all the WSJ and your plan try to do, does not do much to help the people who are losing their homes to the con-man banks, or losing their jobs in massive unemployments.

    The health of the country is not determined solely by the GDP, the S&P, or the Dow, but by the quality of life for everyone.

    I hope you will return to more productivity based topics rather than becoming another echo of “Rush” and his cohorts.

  • Greg

    Great post. I think Reboot missed the point of the article. Government is not able to increase the quality of life of its people. Instead it is the innovations and creations of private individuals that maximize quality of life for everyone. Perhaps a day or two in a government subsidized housing project would change his perspective.

  • http://www.linkedin.com/in/heartburnhomeremedy Heartburn Home Remedy

    This topic is quite trendy on the Internet at the moment. What do you pay the most attention to when choosing what to write ?

  • Matt

    A couple of things. First, the purpose of this blog governs what I write: productivity in work, life, business, and society. I see economics as integral to the issue of being productive as a society.

    Second, I write on what interests me. This subject interests me because economics interests me.

    Anyway, those are two of the main things: the scope of the blog, and my interests. And all of that with serving the reader ultimately in view.

  • Murphy

    The reason Obama won’t cut taxes is that the poor would not benefit directly, as they pay no income tax. They would only benefit indirectly, through increased job opportunities. Obama panders to the poor in a way that they can appreciate: by giving them immediate handouts for producing nothing.

    While this may secure his base of the 45% or so non-taxpayers, it means ruination for the economy.

  • chuck

    what is missed here is that to keep this system going wages are kept low or are removed through technology. Makes a nice profit but leaves people with little money. So the value of evrything must come down. The profit incentive is good for investors up to a point. then what? someone has to buy stuff.