A Tax Bill that could Increase the Deficit and Lead to Recession.

Richard Green

Lusk Chair in Real Estate, Professor, Price School of Public Policy and Marshall School of Business, University of Southern California


I am a Keynesian.  By that I mean that John Maynard Keynes’ predictions are generally confirmed by evidence—and that the key to economic vitality is aggregate demand.  While Keynes has been dead for more than 70 years, new evidence suggests that his educated suppositions developed during the great depression were generally correct.

For example, my USC colleague Rodney Ramcharan, along with Raghuram Rajan, have shown that people who received mortgage payments cut when their adjustable rate mortgage payments moved downward with interest rates from 2008-2012 spent a good share of their increase in after house cost income.  This refutes a particular view of Keynes’s critics, who argue that people tend to smooth consumption so it remains the same from one year to the next, and so that shocks to income should have little impact on consumption.

Even more problematic for Keynes’ critics is work by UCLA’s Francois Geerolf, who showed that changes in property tax payments created multiplier effects—that a one dollar cut in property taxes will actually create a $2 increase in spending.  Anti-Keynesians have argued that multipliers are “incoherent,” and so they are, but only in times of full employment.  The argument for multipliers during times of economic slack, however, is straightforward—if new demand leads someone to become employed, that employed person will also spend money—money that he/she didn’t have before. Given that the current share of 25-54 year olds that are employed is still below peak (according to the Bureau of Labor Statistics), some slack likely remains in the economy.

And this is why a tax bill that partially pays for tax cuts in the corporate sector by raising taxes on the consumer sector, and why a bill that partially pays for tax cuts on high income individuals by raising taxes on low income individuals (I take this from the Joint Committee on Taxation’s Analysis of the Senate Tax Bill), could lead to a recession, despite the fact that it would expand the deficit.

The argument behind cutting corporate tax rates is that it would lead to a corporate spending boom.  Cutting taxes on corporations would mean that corporations would have more cash on their balance sheets—cash they could use to invest more in capital.  But capital spending is not the only thing management could use the cash for—they could use it to pay themselves more, to pay higher wages, to pay our more dividends, or to repurchase outstanding shares.

Yet we are in a world where corporations have, according to S&P, a record amount of cash on their balance sheets.  This cash is earning very low rates of interest—surely investing the money would earn a higher rate of return than letting it sit.  Still, corporate leaders have decided that there is not enough future demand for their products to justify investment.  And so the money sits.  It has hard to see how advancing corporations more cash will produce more capital spending.

But the tax proposal would raise taxes on lower income and middle income Americans—the people who actually spend their incomes.  A one dollar tax increase on a lower-to-middle income taxpayer will cause spending to fall by at least a dollar (the research I cited above suggests that the impact might be more)—such households have little savings to cushion the consumption effect of a tax increase.  The high-income people who would get large tax cuts, on the other hand, would likely not change their spending very much (or if they do, it might be on things like rare paintings that were produced many years ago, and hence represent an exchange of assets, rather than spending on something that might employ people).

In short, the tax bill that, via deficits, could lead at once to higher interest rates (particularly if our trading partners face more impediments to exchanging their goods for our assets, but that is a subject for another time), and less growth, and therefore fewer jobs.  That it is clearly regressive as well is the artificial sweetener topping for the dried out fruit cake.

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