The Heritage Foundation

WebMemo #854 on Taxes

September 21, 2005

September 21, 2005 | WebMemo on Taxes

Deeply Flawed CRS Katrina Study Urges Return to 1960s Fiscal Policy

The Congressional Research Service's recent report on fiscal policy responses to Katrina is almost entirely based on the widely discredited Keynesian theory that more government spending is a recipe for economic growth. Indeed, it is a surprise to find the Congressional Research Service producing this kind of analysis-particularly given the large advances in the economics profession over the past 40 years regarding the relationship between fiscal policy and economic performance.

 

The Congressional Research Service (CRS) analysis is deeply flawed. It fails to properly define growth, and so it is hardly a surprise that it does not offer a correct prescription for more growth. The author seems to believe that the key to growth is boosting consumer spending, but this merely alters how people use their income. Economic growth, by definition, occurs when people earn more income. How they then use their income is of little importance. They may consume their income, or they may save their income (meaning that others will borrow the money and spend it), but it puts the cart before the horse to assert that the use of income determines the level of income.

 

Bigger Government Means Less Growth

Having claimed that consumer spending is an economic elixir, the report commits another remarkable error by stating that bigger government is the best way to boost consumer spending. According to the author, government handouts put money in people's pockets, which they will then spend. But this simplistic analysis overlooks the obvious issue that government programs cannot put money in people's pockets without first taking that money-either by taxes or borrowing-from the productive sector of the economy.

 

If bigger government were the key to growth, the United States would have prospered in the 1970s and Japan would have boomed in the 1990s. Governments that try to spend their way to prosperity inevitably experience less growth because resources are generally used less efficiently when allocated on the basis of political criteria instead of market-based decisions.

 

By contrast, nations that impose some discipline on government spending enjoy faster growth. Ireland, Slovakia, and New Zealand are examples of nations that significantly reduced the burden of government spending. In each case, the amount of economic output consumed by government was dramatically reduced in a relatively short period of time. According to Keynesian theory, this should lead to recession. In the real world, however, smaller government helped boost economic growth in these nations.

 

CRS Botches Tax Cut Analysis

In addition to a bungled analysis of government spending, the CRS report has a similarly mistaken view of tax policy. Almost all economists recognize that changes in tax policy can impact economic performance, but only if those changes alter incentives to engage in productive behavior. This is why some tax cuts-such as lower marginal tax rates on work, saving, and investment-have a positive impact on growth, while other tax cuts-such as credits, rebates, and deductions-have very little if any impact on economic activity.

 

Yet the CRS report once again relies solely on the old Keynesian theory and assumes that tax cuts can only help the economy if they boost consumer spending. The report actually states, "The most effective way to stimulate the economy through fiscal measures is to increase direct spending, or to provide tax cuts to people who are likely to spend most of it, which are likely to be lower and moderate income individuals… Since the lowest income groups do not pay income taxes, only measures directed at earned income tax credits or refundable child credits are likely to reach these individuals."

 

What makes this passage so astounding is that America experienced a Keynesian tax cut in 2001 and a "supply-side" tax cut in 2003. The economic impact of these two tax cuts indicates that Keynesian theory is bad in theory and in practice. The bulk of the 2001 Bush tax cut was in the form of tax rebates, tax credits, and other provisions that did not impact marginal tax rates on work, saving, and investment. There were some very good provisions in the legislation, but they were back-loaded and not scheduled to take effect until 2004, 2006, and 2010. If Keynesian theory were accurate, these special tax breaks should have boosted growth. Yet there is very little evidence that the 2001 tax cuts improved economic performance.

 

By contrast, "supply-side" provisions accounted for the lion's share of the 2003 tax cuts. The 2003 legislation lowered marginal tax rates on dividends and capital gains to 15 percent, substantially reducing the double-tax burden on saving and investment. Moreover, the bill also implemented-effective immediately-the marginal income tax rate reductions from the 2001 legislation. Not surprisingly, the economy has been growing much more rapidly since the 2003 legislation was adopted.

 

Amazingly, the CRS analysis ignores this recent history. Clinging to the outmoded Keynesian mindset, the report actually argues specifically against pro-growth tax cuts, complaining that these tax cuts benefit, "…individuals who are less likely to spend income, especially the rate reductions, the estate tax repeal, and the lower taxes on dividends and capital gains." But as stated earlier, the goal is convincing people to earn more income, not to spend more of their current income. This is why lower marginal tax rates are important: They lower the tax burden of additional productive behavior. The 5 million jobs created since the 2003 tax cuts are just one sign that this "supply-side" approach is more successful.

 

Conclusion

The CRS report is a throwback to the 1960s, an era before empirical data confirmed that Keynesian theory was mistaken. It is surprising to see this approach seriously discussed in the 21st century. Policymakers can safely ignore this discredited analysis. Unless, of course, they want to make America more like France and other stagnant welfare states.

 

Politicians already have appropriated $62 billion in response to Katrina, and it is safe to predict that more money will be spent. This new spending may or may not be an appropriate way of dealing with the disaster, but policymakers should recognize that it is not a recipe for faster economic growth.

 

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes