Wednesday, December 3, 2008

Supply Side Stimulus

Richard Rahn of the Cato Institute outlines an economic restoration plan in an op-ed for the Washington Times today. He also bashes the “Keynesian claptrap”, which is always fun. I liked some of the proposal, so I wanted to expound on it.

1. Cut payroll taxes for two years – Payroll taxes are the FICA and Medicare taxes removed from your paycheck. Of these taxes, you pay half and your employer pays half. By cutting this tax, tax home pay for the employee increases and employment costs for the employer fall. This should give more incentive to hire.

However, because the tax cut is temporary the effects will be small. It is unlikely to see much increase in demand for professional positions as companies generally expect new professional hires to spend several years at the firm. The unemployment rate for college educated people is also generally very low (~2%) and doesn’t tend to spike as much during recessions.

For low-skill labor this could be a boon. Unemployment rates for low-skill labor is often quite high (~8%) and tends to jump quite a bit during recessions relative to other labor demographics. Employers who simply need warm bodies don’t expect that these employees will make a career of flipping burgers. This temporary measure could have a worthwhile impact to alleviate temporarily unemployment.

Given that there are some benefits, this would be a less bad stimulus than direct government spending. The tax cut encourages more output, and allows businesses to allocate efficiently the resources to profitable ends. The drawback is that it still requires borrowing, which gives incentives to move capital from its most efficient allocation to one less so. It may help your local Jack in the Box, but only at the expense of your local biotech startup looking for a loan. I just don’t think there are enough positive supply-side effects from this kind of tax cut to mitigate this fact.

I say "less bad stimulus" than government direct spending because of the points that Mr. Rahn makes:

Some advocate government spending on infrastructure as part of a stimulus package. In theory, government infrastructure spending (highways, bridges, dams, etc.) can help the economy: if the project meets a solid cost-benefit test; if it is well-managed; if there is little or no corruption; and if it can be done quickly to help the current downturn. Do you want to bet your tax dollars on all of those "ifs"?
2. Cutting Corporate Income tax – This idea I can more whole-heartedly support. First, and foremost, we would become more competitive internationally. In the long run, more operations would be located here in the United States. Sure there are countries who have labor so cheap that we can not compete for the lowest skill jobs, but we can compete for high wage/high skill jobs. As Europe continues to cut their corporate tax rates, it will become more and more pressing for the U.S. to do the same. Secondly, there is an immediate benefit. My company has (legally) arranged business operations to move profits out of Japan to the United States to save on taxes. We have done the same to move profits from the U.S. to other low tax countries. If those profits were repatriated, the tax flows would stay in our country and no theirs.

The other effects of cutting the corporate tax rate that I like are gains in efficiency and drops in lobbying. If companies are paying less corporate taxes there is less incentive for them to engage in creative tax accounting. These people and resources could be employed in more productive tasks. In a similar way, lower tax rates gives less incentive to game the tax code through lobbyists.

It would still require borrowing to replace this tax revenue, but I think there are enough supply-side effects to make this worth doing.

3. Assuring the market that capital gains taxes will not be increased – This costs nothing and would help our ailing stock markets. Some of the market drop is based on fears of Mr. Obama’s campaign pledges to increased capital gains taxes. The capital gains tax is by far the most destructive form of taxation the government imposes. History has shown that raising this tax actually lowers tax revenue, and drags down economic growth by destroying capital. Higher capital gains taxes are a lose-lose proposition.

Mr. Rahn also encourages allowing individuals to reclaim taxes through capital losses. I completely disagree. This would exacerbate the already pro-cyclical nature of tax revenues. It would be better just to get rid of them.

In general, good ideas. I have toyed with the payroll tax cut before, but it doesn’t look like a panacea. So, I shrug my shoulders at the payroll tax cut, and give a big thumbs up to cutting corporate tax rates and maintaining current capital gains taxes.

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