Monday, July 18, 2011

Spending Cuts and Tax Increases

By Lewis Sage

In an article titled Politicians Can’t Agree on Debt? Well, Neither Can Economists, (NYT, 7/18/11) Binyamin Appelbaum outlines the debate over whether tax increases or spending cuts would do more to reduce growth and dampen recovery.  “A $100 spending cut reduces economic activity by $100, while an equivalent tax hike will be paid partly from savings, so that spending is reduced by smaller amounts,” (A11) writes Appelbaum, an answer that is worth at least 8.5 out of 10 on a Principles of Macroeconomics exam, depending on how the question was phrased. If we typically save about $5 out of every $100 of additional income, then the first-round impact of a $100 tax increase means only a $95 decrease in total spending, as opposed to a $100 decrease from the reduction in government spending.  Call this Scenario 1.
The problem, as Appelbaum points out later in the same article, is that at least some empirical studies show relatively larger effects from tax changes than from spending changes.  Time to revise the model?
Perhaps part of the answer is that decreases in government spending do more than lower income.  Some of what the government buys for us are private sector stuff (primarily services) that at least some of us are willing and able to buy for ourselves.  In that case, households would end up saving less, both because income is lower and because we would continue to buy some of the stuff formerly provided through the government. Private sector consumption (financed by reduced saving) would be substituted for some fraction of the public sector spending previously done on our behalf.
Back to our numeric example.  Suppose that, when government spending is cut by $100, private spending increases by $10, in an attempt to buy some of what the public sector is no longer providing.  Tax increases, as before, would be partially financed with $5 in reduced private saving.  Call this Scenario 2. 
A few back-of-the-envelope calculations (which I will spare you) lead to the following.
Spending Cut Scenario 1
Tax Increase Scenario 1
Spending Cut Scenario 2
Tax Increase Scenario 2
GDP falls $2000
GDP falls $1900
GDP falls $1800
GDP falls $1900
An over-simplified model?  Sure.  But what it suggests is that if households substitute private for public spending by more than the fraction of income that they save, tax increase would damage economic recovery more than would equal spending cuts.
So are the Republicans right in trying to close the federal deficit with spending cuts alone?  No, but the argument against that position has at least as much to do with social justice as it does with the growth of the economy.

Dr. Lewis C. Sage likes intersections. Since 1991, he has taught Law and Economics, Mathematical Economics, and the Economics of Healthcare. A former Fulbright Fellow (Bulgaria 1995-6), he teaches an interdisciplinary Honors seminar, Enduring Questions, and is studying strategy in the NFL draft with faculty and students in Sports Management and Psychology. E-mail:

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This blog lives under the auspices of the Department of Economics whose mission has been to hold high the lantern beaming an "economic way of thinking" onto the world. Selfishness, rationality and equilibrium have been central to the teaching of an economic way of thinking rooted in the Renaissance. And, in this regard, the department has faithfully stayed the course. The intent of this blog, thinking out loud..., however, is to entertain exchanges which may challenge the centrality of economics as we teach it.