We’re all aware of how crude Keynesianism is: In a recession, the politicians should be allowed to spend the hell out of the deficit and everything will become entirely peachy again. Amazingly, this is an idea very popular among those who have become politicians, because they enjoy spending other peoples’ money.
It’s also not a policy which has a great deal of evidence to support it in detail. The underlying idea has its merits, certainly, but there’s a catch to it. The catch being that what the politicians spend the money on might itself be a waste of resources.
That underlying idea is that there are times, in a capitalist and/or market economy, when we all get stuck at an equilibrium below full output or full employment. Certainly there are arguments against this idea, but let us just accept it for a moment. The answer when this does happen is for government to deliberately engineer a burst of demand that then shocks us off this unwanted equilibrium, up onto one where all who want jobs have one, we’re using all the resources of the economy, and we’re getting richer. This is then taken to mean that the government should borrow (or even just print the money) to spend lots more to produce that demand. But that’s not explicit, nor even implicit, in the underlying idea.
For it is the addition of demand to the economy that produces the result. In the model, borrowing to spend does this — but so would reducing taxes while keeping spending constant and borrowing to fill that gap do the same. Politicians who are there to spend other peoples’ money like this idea a lot less. But then, why should we be running the government for the politicians’ sake? Surely we should be running it all for us.
The idea of reducing taxes does run into a problem: Ricardian equivalence. We see taxes cut and spending stay constant, we assume that taxes will rise in the future, so we save the tax cut to pay that future bill coming down the pike. Equivalence is true for a few of us all the time, for some of us none of it, and for enough of us, sometimes, for it to make a difference.
Fortunately, President George W. Bush tested this for us.
There were two sets of tax cuts in response to the beginnings of the Great Recession. We found that when people got a “chunk” of money, a few hundred dollars in a check, that they saved it or paid off debt (economically the same thing). Not what we wanted and that Ricardian equivalence. But when they got smaller amounts more regularly, they went out and spent it. For example, when a reduction in payroll taxes increased weekly incomes by a few tens of dollars, then it was all spent. Ricardian equivalence didn’t hold. Cutting the payroll tax, therefore, would be that Keynesian stimulus to gain that change in the equilibrium, and therefore all is peachy.
Consider a Swedish study on the effects of reducing the payroll tax.
The policy was pitched by proponents as a way to stimulate employment among the young and business activity. It was criticised by opponents — who ultimately repealed the tax cut in 2015 when elected — as a costly give-away to employers. The positive employment effects, particularly in high-unemployment regions, align more with the former view than the latter. Furthermore, the tax cut stimulated business activity and was in part redistributed back to workers.
Excellent, we seem to have done what we wanted to do: stimulate employment and demand by reducing payroll taxes. The thing is though, John Maynard Keynes himself realized this. Sadly, he realized it a little after he’d written the book that everyone refers to, so too few realize that he did:
[Y]ou are able to show fluctuations in income of an order of magnitude which is significant in the context. … So far as employees are concerned, reductions in contributions are more likely to lead to increased expenditure as compared with saving than a reduction in income tax would, and are free from the objection to a reduction in income tax that the wealthier classes would benefit disproportionately. At the same time, the reduction to employers, operating as a mitigation of the costs of production, will come in particularly helpfully in bad times.
Like many others, I’m not entirely convinced by the Keynesian argument in the first place. However, why don’t we start insisting that if we’re going to do Keynesianism, we should actually do it properly?
Next time there’s a recession, instead of letting the politicians spend the heck out of our children’s wallets, why not just start insisting that they should be taking less out of ours in payroll taxes? As the evidence shows, as Keynes agrees, this works. And who could complain about that except those spendthrifts in Congress?
Tim Worstall (@worstall) is a contributor to the Washington Examiner’s Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute.
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