On the Meaning of "Tax Cuts Must (Usually) Be Paid For"
[M]y inquiring mind wants to know why Brad is worrying about “funding” tax cuts…. Here I only examine the notion that you must “pay for” tax cuts by either higher taxes or lower spending…. No analogy is perfect…. Economists often use a bathtub analogy to explain stocks and flows: water runs into the bathtub from the faucet (in-flow) that fills the tub (stock), so long as the water running out of the drain (out-flow) is less than the water running into the tub. If we plug the drain, the water stops running out—so the in-flow fills the tub. Brad wonders how do we “fund” the reduced outflow? I think that is a nonsensical question. Now, he might instead have wondered: what do we do when the tub is full? Would it then make sense to open the drain, or to slow the flow from the faucet? Sure. But how is that “funding” the previously reduced outflow during the period in which we closed the drain?
The answer, IMHO, is that reducing the outflow--lowering tax collections--means that that date is closer at which the tub is full and we have to either open the drain (i.e., raise taxes) or slow the flow from the faucet (cut spending).
Randy continues:
Makes no sense to me…. Tax cuts today cannot be “paid for” later by tax increases or spending reductions. There could come a time in the future when we decide that aggregate demand is too high—perhaps sparking inflation. At that time we might raise taxes, or cut spending, or stimulate more production, or use non-price rationing, or institute wage and price controls, or… who knows? But if and when we take those actions, they do not “pay for” today’s tax cuts.
To this my response is: yes they do.
Cutting spending in the future when you would not otherwise have done so is paying for today’s tax cuts. Raising taxes in the future when you would not otherwise have done is is paying for today’s tax cuts. Introducing non-price rationing to diminish aggregate demand--as a way of telling people: “You know that money you loaned us and we promised to pay back with interest so that you could then spend it? Well, guess what? You can’t spend it!”--is paying for today’s tax cut with a rather sneaky future tax. And so are wage and price controls. And so is the implicit tax on holdings of government debt via explicit inflation.
Now the terms on which you pay in the future for today’s tax cuts are wildly variable, and it is the business of fiscal policy for the government to be a good steward for taxpayers and set things up so that the terms on which the government pays for what it does are as attractive as possible. And there certainly are times--like right now--when at the margin at least it looks as though additional government purchases are at least at the margin free, in what we hope is only a once-in-a-lifetime opportunity.
But odds are that the tub will fill. And odds are that larger government deficits over the next twenty years will bring the date at which the tub fills and policy has to change closer in time. And it would be only prudent to have a plan for how to push off the time at which we will have to deal with the full bathtub or at least to have a plan for how to deal with the full bathtub.
