The Pump's Already Primed So Hold the Tax Cuts

Government spending on infrastructure would do more for the economy.

Didn't that guy once play the drums?

Photographer: Oli Scarff/Getty Images

Donald Trump has proposed cutting taxes as a way of “priming the pump” -- that is, stimulating the economy. Paul Krugman retorts that now isn't the time for stimulus; because the economy is doing fairly well right now, the pump is already flowing, so the government should wait until it runs dry to start priming.

Whether stimulus could help the economy is an interesting question, but it’s not the most important thing to be asking. The real question is whether tax cuts are the right thing to try. And the answer is probably not.

Lots of people like the idea of tax cuts as stimulus. According to standard economic theory, taxes distort the economy and harm efficiency. And basic Keynesian theory says that tax cuts stimulate the economy in bad times. Therefore, if you want to get out of a recession, why not reduce taxes, thereby killing two birds with one stone? Economists who think taxes should be as low as possible tend to see the fiscal stimulus aspect as an added benefit.

Republican presidents have often taken advantage of this ambiguity. Enacting tax cuts, they leave it to observers to decide why any positive effects occurred. As Silicon Valley conservative Peter Thiel once quipped:

A mischievous person might even ask whether “supply-side economics” really was just a sort of code word for “Keynesianism.”


Unfortunately for Trump, this wisdom probably no longer holds. Even if tax cuts once had the power to boost the economy, they are unlikely to do so now.

First, classic Keynesian theory says that tax cuts are a much weaker stimulus than government spending. In a depressed economy, there are unused resources that need to be put to work -- idle factories, empty office buildings, workers sitting around at home because they’re unable to find a job. The idea of stimulus is to match the unused workers with the unused factories and office buildings, by having the government spend money that filters through the economy.

If the government hands out money to people via a tax cut, they’ll spend some of it and save some of it. The portion that they spend will raise demand and stimulate the economy. But the portion that they save will just go into a bank vault and not do much to stimulate the economy. If they save all of their tax cut, there’s no stimulus at all -- in fact, some econ theories predict exactly this. More realistically, saving only cancels out part of the stimulus effect, not all.

But now consider what happens if the government spends money directly on things like repairing roads or fixing leaky pipes. In that case, the money goes into the hands of the road workers, pipe fixers and owners of the companies that build roads and fix pipes. Now these people get to decide whether to save or spend their new income -- just as if they had gotten it in a tax cut. But in the meantime, all the road workers and pipe fixers definitely got jobs, and society now has nice roads and pipes.

Also, it’s worth noting that tax cuts go mostly to the well-off, because the wealthy and the upper-middleclass shoulder much more of the tax burden. But the well-off have much higher savings rates than the poor and working-class:

The Luxury of Not Spending Every Paycheck

Savings rates by wealth percentile

Source: Gabriel Zucman, "Wealth Inequality in the United States Since 1913"

Therefore, pipe fixers and road workers are likely to spend more of any government windfall than the typical recipients of a tax cut.

So for those two reasons, government spending is generally thought to have a higher fiscal multiplier than tax cuts -- a dollar that the government spends in a recession tends to get circulated more through the economy than a dollar handed out in tax cuts. Not all economists agree with this, of course. It’s very hard to get reliable estimates of fiscal multipliers -- estimates can range from less than zero to five or higher. But the bulk of the existing evidence suggests that the classic theory is broadly right -- spending packs more of a stimulus punch than tax cuts.

What about the long-term benefits of tax cuts? These were probably large back in the 1960s, when Presidents John F. Kennedy and Richard Nixon cut income taxes from their extremely high postwar levels:

A Declining Cut of the Action

Top marginal federal income tax rates since World War II

Source. Tax Foundation

When President Ronald Reagan cut taxes again in the early 1980s, the effect was probably moderately positive. But by the time President George W. Bush slashed taxes again in the 2000s, the magic was gone -- taxes were now so low that cutting them more only raised the deficit rather than making the economy more efficient. A similar tax cutting experiment in Kansas, under Governor Sam Brownback, has yielded equally disappointing results.

So tax cuts won’t do a great job of priming the pump, and they won’t make the economy much more efficient at this point. A much better idea, therefore, is for President Trump to focus his efforts and his political capital on his promised infrastructure spending plan. Infrastructure isn't just something the U.S. economy needs right now, it also makes for a much better fiscal stimulus.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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