The “Tax Cut” Bill

I have problems calling the bill currently in Congress about tax rates a “tax cut” bill.  Yes, there are some genuine “cuts”.  But most of it is fake cuts.  Congress and the Bush administration made a promise 10 years ago to raise our taxes at this time.  Now the current Congress decides to not actually do the previously-promised increase.  That’s not a real “cut” in my book, it’s a reprieve from a threat.  I mean, suppose I hold a gun to your head and promise to shoot you next Sunday. Then on Saturday, I decide to drop the gun and not shoot you for another two weeks.  Can we really say I “saved your life”?

Nonetheless, since everybody seems to want to call it a “tax cut” bill, I will too.  So what’s my take on the bill? It’s bad, very bad, and very poorly done.  But it’s also necessary at this time.  It’s probably the best we can get with this Congress and this President.

Most important, while necessary, it won’t do the job people want it to do.  People want genuine recovery. People want jobs and the unemployment rate to decline from near 10% back down to full employment (under 5% at least).  This bill won’t do that.  It’s too small.  And, it’s structured wrong.

First, it’s too small.  The biggest problem with the original Obama stimulus bill (there were several problems) was that it was too small.  It was clear by December 2008 that we needed a fiscal stimulus at least twice as big as what we got. And we needed it extended for longer. Politics triumphed and we got a bare-bones.   Instead of triggering recovery, it simply stopped the decline.  This bill repeats the mistake. While at first it looks big ($857 billion), most of it is simply perpetuating the current tax rates  – little new stimulus.  What stimulus is there, the unemployment benefits extension and the payroll tax cut (Social Security tax) amounts to maybe $200 billion or so for one year.  At best, I expect this bill to help lower unemployment to 8-8.5% during 2011.  Not enough.

Second, it’s poorly structured.  Despite the fury, rage, and disdain conservatives claim to have for “Keynesianism”, make no mistake. This is a Keynesian stimulus bill.  A poorly designed one, but one just the same.  Why?

There are two ways to implement stimulus fiscal policy: increase government spending or decrease taxes.  This bill is almost all decrease taxes.  The problem with cutting taxes as a way to stimulate the economy is basic Econ 202 principles stuff.  A tax cut may get saved, put in the bank, or used to pay down debt.  Not all of it gets spent by households.  Without the spending, no stimulus.  With this bill slanted towards tax cuts for the higher income folks it is highly likely that much of it will be saved or used to pay down debt.  The only real spending part is the extension of unemployment benefits.  That stimulus money gets spent immediately and helps generates demand for jobs.  For evidence, see here.

There are more problems with the bill, but I’m out of time right now and will address them in another post.  In particular, there are possible consequences for Social Security.

Tax Cuts, Deficits, Debt

The current bill finding it’s way through Congress from Senate to House regarding “tax cuts” will add to the deficit.  How much? $857 billion worth.  That means that this bill, which is in fact a stimulus bill, is actually a bigger stimulus bill than the one Obama and Congress passed in February 2009. The earlier bill was only in the $780 billion range spread over 2.5 years.  This is $857 billion over 2 years.

Tax Bill to add $857 Billion to Debt

by CalculatedRisk on 12/09/2010 11:10:00 PM

From Bloomberg: Senate Tax-Cut Extension Plan Would Add $857 Billion to Debt

The congressional Joint Committee on Taxation, which estimates the revenue effects of tax legislation, said the provisions would cost the government $801.3 billion in forgone revenue over 10 years. Extending unemployment benefits for 13 months, another feature of the package, would cost $56 billion, the Obama administration has said.

It is important to remember the Joint Committee on Taxation assumed all the provisions will end as scheduled; the payroll tax cut after one year, and the other tax cuts after two years. That seems very unlikely, so the actual cost will be much much higher. As an example, if the tax cut for high income earners stays in place for the next decade that will add $700 billion alone to the debt!

Also, the vast majority of the impact is from extending the Bush tax cuts.

Nope, No Inflation Around Here

The folks who have been opposed to stimulus, either by the government or The Federal Reserve, keep raising the specter of inflation.  Often they drag out the ghosts of hyperinflations past in places like 1923 Weimar Germany or modern day Zimbabwe. It’s always eithere inflation or government “bankruptcy” that’s just around the corner.  It’s supposedly this imminent inflation that will ruin us and that’s why, we’re told, we must tolerate unemployment of approx. 10% (worse if you count underemployment).

Over two years ago, these same people told us the Federal Reserve’s massive injection of reserves to save the banks would bring hyperinflation.  Nearly two years ago we were told Obama’s stimulus bill would bring deficits that would necessitate currency debasement and inflation.  More recently we’ve been told that the Federal Reserve’s QE2 securities buying operation would debase the currency and bring inflation and ruin.

Nonsense.  There’s no looming inflation or hyperinflation. Period.  This fear-mongering of inflation is born of bad, disproven theories.  (I hope to post more about that in the future).  For right now, let’s look at the data.

Calculated Risk updates us with the latest numbers just released for November 2010 below.  What all this econ-data-talk means is that no matter which data series you use, no matter what your favorite measure is, the year-over-year inflation has been less than 1%. And that is down from earlier:

In addition to the CPI release this morning from the BLS, the Cleveland Fed released the median CPI and the trimmed-mean CPI:

According to the Federal Reserve Bank of Cleveland, the median Consumer Price Index rose 0.1% (1.0% annualized rate) in November. The 16% trimmed-mean Consumer Price Index increased 0.1% (1.1% annualized rate) during the month. …

Earlier today, the BLS reported that the seasonally adjusted CPI for all urban consumers rose 0.1% (1.5% annualized rate) in November. The CPI less food and energy increased 0.1% (1.2% annualized rate) on a seasonally adjusted basis.

Over the last 12 months, the median CPI rose 0.5%, the trimmed-mean CPI rose 0.8%, the CPI rose 1.1%, and the CPI less food and energy rose 0.8%

So these three measures: core CPI, median CPI and trimmed-mean CPI, all increased less than 1% over the last 12 months.

Inflation Measures Click on graph for larger image in graph gallery.

This graph shows these three measure of inflation on a year-over-year basis.

They all show that inflation has been falling, and that measured inflation is up less than 1% year-over-year.

Note: The Cleveland Fed has a discussion of a number of measures of inflation: Measuring Inflation

Now there’s another way to think about inflation. Instead of asking how much prices have gone up, we could focus on what people think prices will increase.  The best way to do this is to not only use different surveys, but also to compare the prices between government bonds that are not indexed for inflation with government bonds that are indexed for inflation. Fortunately, as Mark Thoma points out, The Cleveland Fed bank does that for us.  Here’s what they say:

Cleveland Fed Estimates of Inflation Expectations: The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.64 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade. … Estimates are updated once a month, on the release date of the CPI.

Latest Estimates

(Click on the image to enlarge.)

Nope. No inflation around here.  No prospects for inflation around here.  Plenty of unemployed, though.

The Necessity of Extending Unemployment Benefits

James Hamilton at Econbrowser summarizes my thoughts too:

Extending unemployment benefits

Here I make two quick observations on the policies being discussed.

The first point has been widely noted, but it bears repeating since I keep hearing comments from people who seem to be unaware of it. When you hear that current unemployment benefits can in some cases be collected for up to 99 weeks, and that Congress is discussing an extension of this program, it is perhaps natural to think this means that some people might be eligible for longer than 99 weeks. But this is not the case. Instead what is being discussed is whether the current limits will be kept in place for another two years or whether the limits will be decreased immediately.

The second point to which I’d like to call attention has also been around awhile, but is appropriately still being discussed (e.g., Calculated Risk, Washington Post). The source appears to be these observations made by Wal-Mart CEO Bill Simon in September:

And you need not go further than one of our stores on midnight at the end of the month. And it’s real interesting to watch, about 11 p.m., customers start to come in and shop, fill their grocery basket with basic items, baby formula, milk, bread, eggs, and continue to shop and mill about the store until midnight, when electronic– government electronic benefits cards get activated and then the checkout starts and occurs. And our sales for those first few hours on the first of the month are substantially and significantly higher.

And if you really think about it, the only reason somebody gets out in the middle of the night and buys baby formula is that they need it, and they’ve been waiting for it. Otherwise, we are open 24 hours — come at 5 a.m., come at 7 a.m., come at 10 a.m. But if you are there at midnight, you are there for a reason.

One thing you might take away from such accounts is that the spending multiplier out of compensation for the unemployed is pretty high.

Money spent on unemployment benefits gets into the economy as spending immediately.  Let’s face it, midnight of the day benefits are payable is about as fast it can get.  It’s also evidence that the benefits from last month are totally spent and gone.  That’s economic stimulus.   Tax cuts for millionaires are not high-payback stimulus.  They don’t fully get spent. And they don’t get spent very fast.

Why Do People Work?

Why do people work?  At first it seems an easy question – to get money or earn income is the answer that comes quickly to mind.  Indeed, mainstream neo-classical micro economic theory answers the question this way and uses it to build a model where people (households) make decisions about how much to work (called “labor supply”) as a function of the real wage offered.  There’s a counterpart model where business firms decide how many workers to hire based on the real wage and it’s called “marginal productivity theory”.  It results in a “labor demand” curve. Like moths drawn to lights, when economists are given a “supply” curve and a “demand” curve we must see where they intersect, label that equilibrium, and say all’s well, the market solves everything. We then proceed to use our equilibrium result as block in building an even larger theory or model.  And, in fact, that happens with labor demand and supply.  It becomes a critical part of some mainstream (mostly Classical based) macroeconomic theories.

Unfortunately, this little example also shows economists behaving badly, or at least illogically and unscientifically.  Let’s go back to the beginning.  It’s a huge assumption and leap of faith (or ideology) to go from the casual observation that most people prefer (or need) to get paid for their work to assuming, as mainstream theory does, that money is the only reason people work.  An even greater leap is the assumption that there is a quantitative relationship between real wage rate and the amount of work people are willing to offer.  The mainstream economists assume that work is necessarily a negative, disutility-creating experience. But that is not a logic inference from the observation that people like to or insist on getting paid for work.  It is entirely plausible that people find work a necessary, fulfilling part of life – after all many people are observed to continue working even when they don’t need it financially. If may be that people want balanced lives – a mix of work, leisure, and hygiene.  It may be a mix of these factors. Indeed, research in management and psychology fields suggests it is.

But economists persist in the simplified theory. Unfortunately this leads to misunderstandings and bad models when the economists tackle larger problems like unemployment. Bill Mitchell notes:

The simplest version is that labour supply in the mainstream model (and complex versions don’t add anything anyway) says that households equate the marginal disutility of work (the slope of the labour supply function) with the real wage (indicating the opportunity cost of leisure) to determine their utility maximising labour supply.

So in English, it is assumed that workers hate work and but like leisure (non-work). They will only go to work to get an income and the higher the real wage the more work they will supply because for each hour of labour supplied their prospective income is higher. Again, this conception is arbitrary and not consistent with countless empirical studies which show the total labour supply is more or less invariant to movements in the real wage.

Other more complex variations of the mainstream model depict labour supply functions with both non-zero real wage elasticities and, consistent with recent real business cycle analysis, sensitivity to the real interest rate. All ridiculous. Ignore them!

In the mainstream model, labour market clearing – that is when all firms who want to hire someone can find a worker to hire and all workers who want to work can find sufficient work – requires that the real wage equals the marginal product of labour. The real wage will change to ensure that this is maintained at all times thus providing the classical model with continuous full employment. So anything that prevents this from happening (government regulations) will create unemployment.

If a worker is “unemployed” then it must mean they desire a real wage that is excessive in relation to their productivity. The other way the mainstream characterise this is that the worker values leisure greater than income (work).

Macroeconomists, thinking they have firmly built a macro theory on some “micro foundations”, assume that involuntary unemployment (the kind where you want a job but can’t find a job) simply doesn’t exist unless people are insisting on getting paid too much.  It’s absurb, but that has become the foundation of not only macro theory, but micro theories of distribution of income, and modern policy.