Will it all balance?

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The WSJ reports that the Democrats have run away from any vote on the Bush tax cuts. I’d wager that they have not run away from their beliefs.  If they get killed in the November mid-terms, and they probably will, I think they’ll resist using the lame duck sessions to pass any extension. After all, it’s the moderates that are going to be wiped out, and the left wing of the party believes that it’s the Government’s money – not the people’s.

Does this matter?

The blog’s title is a pun on the economic debate surrounding this very question. The theory is Riccardian Equivalence; I’m ambivalent – hence the title.

The theory states that the money has to come from someplace.  If the Government wants to spend (say) 1tn more, it has to raise it by hook or crook. Does it matter if they tax it out of the circular flow or sell assets to savers? Probably – but probably by less than you think.

The arguments that are compelling have to do with efficiency and distributional considerations.  The Government must draw the funds from the circular flow somehow – economics can help us guess at the costs and benefits of the various extraction techniques.

For moral reasons, I prefer selling bonds to taxing folks.  Savers exercise their free choice in the allocation of their savings; taxes are compulsory.

Rahn makes a case for lower taxes in the WSJ.  I don’t find it particularly compelling – mostly because the fact is that the US economy basically has grown at 3%y/y real for the past 40 years.  That’s right, for all the ups and downs and lefts and rights of policy over the last 40yrs, it’s made basically no difference.

For all my ambivalence about the long run consequences of the fiscal mix, I share Rahn’s assessment that the short and long run consequences of changing the tax/debt financing mix are likely to be different.

Thus, if I’m right about the Democrats being on course to allow all the tax cuts to expire, it’ll have a major short run impact on the economy. What is it likely to be? Lower demand and (hence) lower inflation for a while, as would-be government bond holders will take time to re-calc their savings and investment plans.

In a full expiry scenario, the distributional consequences are likely to be very important – the largest proportion of the tax increase will be paid by low to middle income households (their sheer number means they earn most of the money and pay most of the tax).  Few of these households are bond buyers (so they cannot compensate by buying fewer bonds or selling some).  Also, a good number of these households are marginal on their mortgages, and may become delinquent if their after tax income falls.

With inflation already too low, and delinquencies still elevated (realty trac reports record high monthly repossessions in August), this will worry the Fed.