Income tax cuts without spending cuts: hazards to efficiency, equity, employment and growth

Abstract

Samuelson’s “neoclassical synthesis” retrieved the theory of fiscal policy from Keynesian economics to the nonmonetary domain. But no agreement emerged over the right kind of “real” model to adopt. In the neo-Keynesian theory fashioned by Tobin and Modigliani, deficits were anti-growth and inoptimally so, and Tobin argued for budgetary surplus to boost investment. Mundell proposed harnessing budgetary policy instead to the stabilization of employment, which inspired the supply-side case for budgetary deficit through reduced tax rates. Rubin and Summers revived the Wall Street asset market argument for budgetary surplus as a means to low real interest rates, thus to high investment, growth and employment – in the present, not only the future. This paper uses these ideas, some old ideas by the author and some recent modeling in collaboration with Hian Teck Hoon to critique the 2001 Bush income tax cut, with its delayed action and sunset feature. First, the tax cut reduces economic efficiency to the extent it misleads households into overestimating their true wealth, thus over-consuming and underworking. Second, in a nonRicardian economy, the tax cut reduces intergenerational justice, conceived in the spirit of Rawls. Finally, drawing on a model with Hoon combining supply-side and Wall Street channels, the paper argues that the delayed tax cut legislation forces an unambiguous rise of the natural unemployment rate until the tax rate cuts kick in, at which point the net effect becomes ambiguous. JEL classification: E13, E22, E23