The budget deficits will increase taxation!

I am now in New York on business for the next few days then off south to the capital Washington. In this blog I want to outline the horrible scenario that everyone has been predicting would happen – the increasing fiscal deficits will increase taxation. I know that has been on our minds. I have reached the ineluctable conclusion that future taxation will increase as a direct consequence of the current deficits. The tax revenue gained by the government will also reduce future deficits. Wouldn’t it be preferable that we didn’t push future taxation up and instead controlled net government spending? If you believed that you would have rocks in your head. In this blog I will be also be discussing debt, inflation, and other nasties.

Okay, lets level here. The title of the blog was to get attention. Has billy blog finally gone over the edge you were meant to think? Not at all. Taxation will rise due to the deficits but we should be happy about that. Far from being a catastrophe or a future burden on our children the rising tax take will signify that the economy is growing again.

This is how it works. The net public spending adds nominal demand to the economy which has been lost as the non-government sector retreats into saving. If the deficits had not expanded (mainly by the way due to the automatic stabilisers) then the spending gap created by the rising non-government sector would have resulted in inventory buildup – leading to production cuts – leading to employment and income cuts – leading to rising unemployment – all of which we characterise as economic malaise.

The longer the spending gap was left unfilled the worse this downward spiral in real terms would have been. Eventually, the economy would stabilise as decreasing income levels would drive the sum of savings, taxation and imports (the leakages) down until they were equal to sum of government spending, investment and exports (the injections). At this point the income generation system finds a new “equilibrium” where there is no further forces operating to change anything and where the unemployment rate would be peaking. A parlous situation.

The decline would have also created such pessimism that investment would also have declined (as we have witnessed in recent quarters). The growth path of the economy is then flattened by the slowdown in capital accumulation. This makes it harder for the economy to reduce the unemployment stocks that accumulate during the downturn.

When the trough is reached – taxation it at its lowest (for given fiscal parameters) courtesy of the automatic stabilisers.

The reason we wanted fiscal policy to come in early and strong was to provide funding for the rising non-government saving. That is, we wanted fiscal policy to ensure that the dynamic multiplier processes that I just described did not unleash their destructive potential. By providing the funding for non-government saving the government deficit has ensured that the spending gap has been (partially) addressed. Of-course, the extent to which the spending gap is closed and the multiplier process stifled depends on the size of the fiscal intervention.

The government may only partially finance the rising saving which means that the dynamics of the downturn will be attenuated but not fully curtailed. In that case, unemployment will rise but by not as much as it would in the absence of the fiscal intervention. This partial closing of the spending gap is what is happening in Australia at present. The fiscal expansion has put a floor under the crisis but is not large enough yet to really protect employment.

But the injection will help and will hopefully reverse some of the investment pessimism.

It is clear that the fiscal expansion stimulates income generation and provides an incentive for firms to keep producing and paying wages. If the expansion is strong enough it will promote employment growth and more people will be dragged into the tax net. Accordingly, the automatic stabilsers will start working in reverse and the government tax take will rise.

In other words, the fiscal expansion will drive up taxation! More people will be paying tax than before. The tax burden on many individuals will rise – from zero to their marginal tax rate. Why? Because they get a job! Overall, a higher tax burden – in these circumstances – is a sign of an economy that is improving in health.

But of-course, this is not the same thing as saying that the fiscal expansion will require tax rate rises across the board to get the funds necessary to “pay for the deficits”! Government deficits do not have to be paid for – the sovereign government is not revenue constrained.

Now this leaves inflation and debt to be considered. Debt because the naysayers claim rising tax rates will be required to pay off the debt which according to their screwy logic paid for the deficits. Inflation because the naysayers say that the governments may opt to inflate the debt away rather than take the politically difficult path of “fiscal discipline” and raise taxes.

LSE Professor and conservative macroeconomist, Willem Buiter for some reason has influence. His increasingly shrill and groundless attacks on public deficits provide no explanation as to why anyone would listen to him. Anyway, they do listen, and he has recently been warning us all of the impending disaster that is ahead of us as a result of these deficits. In his The fiscal black hole in the US article in the Financial Times (another paper to avoid buying) he says:

US budgetary prospects are dire, disastrous even. Without a major permanent fiscal tightening, starting as soon as cyclical considerations permit, and preferably sooner, the country is headed straight for a build up of public debt that will either have to be inflated away or that will be ‘resolved’ through sovereign default.

If any of this had the remotest connection with reality we might actually be alarmed. He also continues to perpetuate the myth that the US deficit is around 14 per cent of GDP.

… the extraordinary levels predicted for the US Federal deficit for the next couple of years (13 to 14 percent of GDP for the next year and not much less for the year after that), plus the cost of recapitalising the banks, shoring up other wonky bits of the financial system and intervening to bail out rust-belt behemoths like GM and Chrysler are likely to put the general government gross debt to GDP ratio at well over 100 percent.

Readers will know that the actual figure is around 8 per cent of GDP once you take out the central bank payments to banks under the TARP.

And if that didn’t scare the pants of you then Buiter goes on to say that “Even that, however, is only the beginning.” The next part of the shocking future we face is sourced to the social outlays that the US Government is planning – health, education, and an environmental agenda.

But it gets worse – the intergenerational debate – crippling unfunded social security and medical expenses will push the deficit into oblivion.

He then says that “It is obvious that these unfunded liabilities of social security and Medicare will be defaulted on. They will not be met in full.” Buiter then goes through the concentional government budget constraint formulas (primary surpluses and debt servicing – rates of interest against rates of growth etc) – to conclude that “if the entire adjustment were to take place through higher taxes” then the US tax burden would soar to European levels. All of which assumes that the government is revenue constrained.

But Buiter doesn’t believe that the government will be able to raise taxes. Instead he says that his:

… fears about the sustainability of the US public finances is based on my belief that the US public believes there is a Santa Claus: that you can have the higher benefit levels and higher-quality provision of public goods and services without paying the price in the form of higher taxes or user charges.

Well I am sure that the general public doesn’t believe that but they should. The Santa Claus in this case is masquerading as the fiat monetary system. The only constraint on all of this will be the real resources available to meet the nominal demand. All the financing smokescreens – for example, Buiter calculates many ratios and estimates etc in his article to give it some authority and also to scare us all – are irrelevant. If there are real resources available and the production system can muster them then it will meet the nomimal demand impulse coming from the public deficits by expanding production and employment and incomes.

If the production system cannot so respond – either because all resources are being fully utilised then inflation will be the result. When considering the impact of fiscal policy on the economy we cannot perform analysis – as Buiter thinks you can – by ignoring the capacity of the economy to respond in real terms. If there are real resources available then the sovereign government will be able to buy as many hip replacements as the system can provide. Pretending the issue is a financial one diverts the debate from where it should be.

Which brings us to taxes and inflation.

In this context, Buiter offers this:

The result will be a build-up of public debt of such magnitude, that the markets will force the government to choose between inflation and default. The state will choose inflation. It always has done to in the past when the debt burden was exceptionally high … The markets are slowly waking up to the threat of inflation as a solution to fiscal unsustainability in the US. The fact that, in the short run (say for the next 3 years or so) deflation is much more likely than inflation does not help, as markets are hopelessly myopic. But once we get more than 3 years into the future, and certainly more than 5 years, the risk of high inflation (between 5 and 15 percent, say) is a material one.

His argument is that as the US Government:

… starts issuing additional debt worth a couple of trillion US dollars or more each year, the willingness of the Fed to monetise this increased debt issuance will be the key factor determining who will win the game of monetary-fiscal chicken that is just now starting. The independence of the Fed is not securely anchored. A chairman of the Fed who refuses to monetise government debt that the Treasury wants to be monetised, or who wants to de-monetise Federal debt acquired in past quantitative easing episodes when the Treasury does not want the Fed to exit from QE, will be replaced.

Well here is the more likely scenario. In what follows I am abstracting from price bubbles in specific asset classes such as land values. They do not amount to generalised inflation and can be dealt with via specific policies aimed at dampening the demand for those particular assets.

Clearly, sovereign governments should keep expanding their deficits to finance the spending gap. Once full employment is reached it is also clear that nominal demand cannot keep expanding beyond this real constraint. Remember that as the economy is expanding the importance of the deficit reduces because other expenditure components (particularly private investment) start to pick up some of the slack as well. Declining unemployment also brings more workers into the paid income category and their consumption rises a bit (noting that most receive income support anyway).

As the economy approaches the so-called “inflation gap” (where nominal demand growth starts to outstrip the growth in real capacity) then there are various policy options available. First, the government can start to cut spending – that is start to reign back the deficit by reducing its demand for public goods and services. The automatic stabilisers will have already been working to do this without any discretionary policy changes anyway as employment levels rose. But ultimately, discretionary changes might be required. Is that bad? What is the purpose of fiscal policy anyway? To get the economy as close to full employment as possible.

Second, the government may decide at that point that it wants to maintain the share of public goods and services in the overall real GDP mix and in this case it will have to reduce the spending capacity of the private sector by increasing tax rates. Ahh, the conservatives finally scream – you see rising tax rates will be required.

Well maybe and no! No, in the sense that taxes have to be raised to pay for anything! Maybe, if the governments decides that bringing nominal demand growth back in line with real capacity growth is to be accomplished via less private spending. The role of taxes (other than to define a demand for the currency) is to reduce nominal demand by taking capacity to spend off the private sector.

And here is another angle on this. If debt servicing was considered a problem (choking room for other public spending at full employment) then the government could easily increase taxes on interest-earned income. In a single policy stroke it could reduce the debt servicing costs by getting it all back via taxes. The only reason it would do this if the inflationary gap was approaching and they wanted the private sector to have less disposable income – that is, less spending.

None of this has anything to do with financing deficits. The whole discussion has everything to do with responsible macroeconomic policy conduct which should always be aimed at achieving full employment and price stability.

Remember all of this analysis has to be conducted within the context of the concept of fiscal sustainability which requires the public purpose goal of full employment to be the starting point for assessing the fiscal position. Buiter doesn’t even mention employment levels!

I will come back to rigid fiscal rules next.

Anyway, its the weekend in New York and I have no work until early Sunday evening so its time to have fun – where’s the surf?

Travel snaps

I took this at Schipol (Amsterdam) the other day. I thought it represented a good model of understatement.

bank_of_scotland_amsterdam it

This Post Has 3 Comments

  1. Bill, I am relatively new to this blog and still getting a hang of things. If I am not mistaken, you seem to place more importance to fiscal policy than monetary policies.

    For the sake of other readers I am quoting James Galbraith’s article quoted in the blog New Economic Perspectives:
    “… In a crisis, the ratio of public debt to GDP must rise. Why? Because a crisis – and this really is by definition – is a national emergency, and national emergencies demand government action. That was true of the Great Depression, true of war, and true of the Great Crisis we’re now in. Moreover, we’ve designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits. Hooray! This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy. Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.”

    Thats a mini version of what you have put across in the blog, I guess.

  2. Hi Bill,
    While, I believe that creating full employment is one of the primary goals of good government, I also believe that creating and maintaining a good public health system, and possibly a free education system are also of importance. Surely we can have both, since as you put it, the government can buy anything available for purchase..

    Can we also thus define full capacity, as a time when we have a fully funded Public health system, as well as full employment?

    What concerns me, is that the idea of the defecit reducing governments ability to spend, (the federal government is like a household), will be used as an excuse to slowly put in place a US Style user pays health system. The concept of us having to pay back the governments debt is a concept used to justify many conservative/ Neo- Liberal political policies, not just the government refusing to act on unemployment.

    The fetish for surpluses, is used as an excuse, often to take harsh measures in many areas, not just in deliberately keeping unemployment high. Many people who have been unemployed or underemployed, mostly due to the governments inaction on this issue, may not have the funds to purchase their healthcare as they age.

    “The Santa Claus in this case is masquerading as the fiat monetary system.”

    Merry Christmas, for 6 months down the track.

    Enjoy yourself



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