The Five Borough Report


Five Borough Report   June 2003



How to Deal with the Economy Today - and How Not To

Joseph E. Stiglitz

Columbia University, 2001 Nobel Prize Winner in Economics


"Seldom have so few gotten so much from so many." That might be the motto of President Bush's proposed tax cuts.


Bush's Mistake

     As the nation entered the new millennium, it faced three problems. First, the economy was slowly going into a recession, with a stock market bubble about to burst. Second, inequality was growing. While the Nineties had at last arrested the decline in income of those at the bottom of the income distribution, the fruits of that decade's growth went disproportionately to the rich. Third, there were long-range problems, including Medicare and Social Security systems, that were underfunded and an economy that had become addicted to living beyond its means, borrowing more than a billion dollars a day from abroad.

     Clinton bequeathed to Bush large budget surpluses which might have been used to shore up our Social Security and Medicare system, provide badly needed new benefits like long-term care and prescription drugs, and repair America's aging highways, bridges, and airports. Instead, he took advantage of the economic downturn to push for a tax cut, but not one designed to stimulate the economy --and it did not do so to any appreciable degree. Two years later, the economy is still languishing. The cost of Bush's mistake has been enormous. In 2001 alone, we had a gap of some 3 percent between the economy's potential and what it actually produced, which translates into a loss of $300 billion. And because of this mismanagement of national economic policy, it will be lower five, ten, twenty years from now since some of the lost output would have been spent on investments that would have enhanced productivity.

     We now know that the tax cuts were ineffective in stimulating the economy. The tax cuts were oversold as a stimulus; and now we know they failed. In an astonishing feat of fiscal mismanagement, the Bush administration managed to squander the surplus, converting it into a $2 trillion deficit.

How to Stimulate the Economy

     We know how to create a powerful and effective tax stimulus. What is needed is to give money through the tax system to those who will spend it and spend it quickly: the unemployed, the cities and states that are starving for funds, and lower-income workers. A strong stimulus would also be an equitable stimulus: the money, by and large, goes to the poorest Americans, those who have benefited least from the growth of the last quarter century. Giving money to cities and states would prevent cutbacks in educational and health expenditures which can hit the poor particularly hard.

     Basic economic analysis indicates that increased government expenditures can indeed be stimulative, and, in fact, are often more effective as stimulus measures than tax cuts.  The Administration's position largely ignores the central feature of a recession: lack of demand. In a recession, the primary problem is that the nation's firms face a reduction in demand for their products - not that they lack available workers, equipment, or anything else needed to produce goods and services. Indiscriminately injecting cash into such firms through tax breaks, without linking the tax breaks to new business activity, would do little if anything to address the underlying difficulty.  Only when a company faces renewed demand for its products will it end the process of shedding workers and begin to create new jobs. As a result, the primary objective of a stimulus package should be to spur spending on these products.

    States are suffering substantial fiscal stress as a result of the recent economic slowdown. In all states except Vermont, some form of balanced budget rule forces such counter-productive fiscal policies: When the state enters a recession, revenue naturally falls and expenditures rise. The balanced budget rules then force the state to reduce spending, raise taxes, or some combination thereof, which is counter-productive since it exacerbates the economic slowdown.

    Economic analysis suggests, contrary to the statements of some political figures, that tax increases would not in general be more harmful to the economy than spending reductions. Indeed, in the short run (which is the period of concern during a downturn), the adverse impact of a tax increase on the economy may, if anything, be smaller than the adverse impact of a spending reduction, because some of the tax increase would result in reduced saving rather than reduced consumption. For example, if taxes increase by $1, consumption may fall by 90 cents and saving may fall by 10 cents. Since a tax increase does not reduce consumption on a dollar-for-dollar basis, its negative impact on the    economy is attenuated in the short run. Some types of spending reductions, however, would reduce demand in the economy on a dollar-for-dollar basis and therefore would be more harmful to the economy than a tax increase.

     The impact on the economy depends primarily on the propensity to consume, that is, on how much of an additional dollar of income is spent rather than saved, among those who receive the transfer payments or pay the taxes. The more that the tax increases or transfer reductions are focused on those with lower propensities to consume (that is, on those who spend less and save more of each additional dollar of income), the less damage is done to the weakened  economy. The least damaging approach in the short run involves tax increases concentrated on higher-income families. Reductions in transfer payments to lower-income families would generally be more harmful to the economy than increases in taxes on higher-income families, since lower-income families are more likely to spend any additional income than higher-income families. Indeed, since the recipients of transfer payments typically spend virtually their entire income, the negative impact of reductions in transfer payments is likely to be nearly as great as a reduction in direct government spending on goods and services.

    It is worth emphasizing that any state spending reductions or tax  increases are counter-productive at this time: they restrain the  economy at a time when it is already slowing. Given the existence of   balanced budget rules at the state level, some form of federal fiscal relief to states is therefore warranted.

A Five-Point Stimulus Package that Would Work

     First, we should extend the duration and magnitude of the benefits we provide to our unemployed. The unemployed, in a situation like this, are innocent victims. Most of the people being thrown out of work want to work, but our economy is not providing them jobs. Why should they suffer because of economic mismanagement? This is not only the fairest proposal, but also the most effective. People who become unemployed cut back on their expenditures. Giving them more money will directly increase expenditures.

     Since our "safety net" is worse than that of most other industrialized countries, we also need extensive improvements in health care, food stamps, and other kinds of programs. For eight years, the most important part of our safety net has been full employment: people who were let go could get another job because we had such low unemployment. That is not going to be the case for the next six months to a year and a half. That part of our safety net has gone, and we need to put into place an alternative one.

     Second, we need a temporary investment tax credit or expensing, something to stimulate investment. Making it temporary encourages people to make the investment today, when the economy needs it and when our resources are not fully utilized. In 1993 we designed an investment tax credit revision that had a huge bang for the buck. It's called an incremental investment tax credit, and I strongly support moving in that direction.

     Third, we ought to have better backward averaging of taxes, particularly corporate income taxes. This is one of the proposals being discussed within the Administration. One reason why there has not been better backward averaging in the past is tax avoidance; to avoid this problem, it should be limited to those firms engaged in investment activities. If these firms were allowed to have a significantly longer backward averaging, that would help provide them with the funds to invest more.

     Fourth, we need a more extended program of revenue sharing with state and localities. State and local expenditures are pro-cyclical: when the economy goes into a downturn, states and localities typically cut back on their expenditures. This not only weakens the vital public services that are provided at the state and local levels, but also deepens the economic downturn.

     We could put money into the states and localities very quickly through a revenue sharing program that would enable them to avoid the kinds of cutbacks that would affect every part of society. It would be particularly good to direct funds to areas of particular need, like Medicaid and education. There are a whole host of vital needs that are typically provided by state and local programs.

     Fifth, there needs to be an increase in expenditure in high-return areas. It is very clear that there are areas in the public sector that are starved for funds and where returns are very high. For instance, the air traffic control system is woefully inadequate; investments in that area would yield very high returns. We have inner-city schools that are dilapidated; kids cannot learn in the kind of environment some of them face. These are areas in which programs are already underway but in which expenditures can be increased.

    --  Excerpted from "Bush's Tax Plan: The Dangers", New York Review of Books, Mar. 13, 2003; presentation at Center on Budget and Policy Priorities Press Conference, October 12, 2001


June 2003

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