- The Washington Times - Friday, May 25, 2001

Influential legislators are talking about tax policy as if fixing an economic downturn was a simple matter of "putting money into peoples pockets."

Democratic leaders Tom Daschle and Dick Gephardt thus define the issue entirely in terms of revenues lost as though it makes no difference how the planned $100 billion "stimulus" for fiscal 2001-2002 is allocated. Their preference is to keep collecting excess taxes (the surplus) from taxpayers with higher incomes in order to write so-called "rebate" checks to those who contributed little or nothing to the surplus.

After all, if prosperity were just a matter of putting money into consumers´ pockets, what difference could it make if the government takes the money from Smith and gives it to Jones? This redefinition of taxpayer-financed gifts as "rebates" makes no more sense than dropping money from helicopters, yet it is being taken seriously by those who refuse to take economics seriously. Critics call it Keynesian economics. But, as we will see, that is an insult to John Maynard Keynes, the famed British economist of the 1930s.

In his 1945 classic, "The Open Society and Its Enemies," Karl Popper distinguished between "vulgar Marxism" and the actual writings of Marx. In the same vein, printing "rebate" checks to "put money in consumers´ pockets" is vulgar Keynesianism the latest epidemic in the nation´s capital. Consider these examples:

At a hearing of the House Ways and Means Committee, an economist from the McCain-Republican camp testified that the quickest way to stimulate the economy was to cut the lowest tax rate first, since those with low incomes will spend it all rather than waste it by saving. That was vulgar Keynesianism.

Another economist wrote an op ed in a conservative newspaper claiming lower interest rates from the Fed could not help the economy because consumers already had too much debt. That focus on consumers and credit was vulgar Keynesianism.

Fed Chairman Alan Greenspan persuaded journalists to focus on consumer confidence surveys that the Fed´s own research shows have no predictive value at all. The implication that the difference between prosperity and recession rests on consumer sentiment was, of course, vulgar Keynesianism.

Keynes advanced "an investment theory of business cycles," to borrow Hyman Minsky´s description not a consumption theory. He would not have been surprised that the current slump originated in collapsing business profits and investment, not consumer frugality. Consumption grew at a 2.1 percent rate in the second quarter of last year, when the entire economy grew by 5.7 percent. But consumption has continued growing at a 2 percent to 3 percent rate ever since. Investment, not consumption, made economic growth go flat.

Keynes taught that consumer spending depends on national income not that income depends on consumer spending. He did not believe recessions were caused by spontaneous waves consumer frugality, nor that recessions could therefore be cured by "putting money in consumers´ pockets." On the contrary, Keynes understood that recessions are always caused by a collapse of business investment. In his 1936 "General Theory," he wrote that a decrease "in the rate of investment will have to carry with it a decrease in the rate of consumption."And, Keynes added, "Employment can only increase … with an increase in investment."

After Keynes, Milton Friedman and Franco Modigliani received Nobel Prizes for demonstrating that consumption depends on long-term income and wealth, not ephemeral windfalls from rebates or a temporary cut in withholding. A one-time "rebate" that is unrelated to productive activity cannot even be expected to stimulate consumption, much less production. Since the rebate has no effect on permanent income, it can have no significant effect on consumption. Nobody buys a new house or car because of a minuscule one-time windfall.

Business investment has been in trouble because companies have been reporting disappointing profits or losses. Over the past year, profit margins were pinched by rising costs of energy, labor, credit and taxes. As Keynes wrote in 1931, "There is no possible means of curing unemployment except by restoring to employers a proper margin of profit."

What does the slump in profit margins and business investment have to do with consumer spending? Not much. Many of the world´s largest corporations mainly sell to other firms. When consumers go shopping, they are unlikely to pick up something from Cisco, Nortel, Oracle or Sun Microsystems.

Keynesian vulgarization has fostered the foolish habit of gauging the economic benefits of tax policy solely by the amount of money the government loses. The one-year cost of rebates and gimmicks has escalated from $60 billion to $100 billion, but slashing the four highest tax rates to beween 25 percent and 33 percent immediately would cost only $45 billion. The more costly rebate policy is the economic equivalent of tossing taxpayers´ hard-earned money (the surplus) into a wishing well. But using half of that money to begin a durable reduction of tax rates would be extremely helpful.

A permanent reduction in the higher marginal tax rates would help the economy immediately by creating expectations that a larger portion of future income will be available to repay debts and rebuild saving, rather than to pay taxes. By contrast, doling out little "rebate" checks that are totally unrelated to taxes paid would be an expensive way to accomplish literally nothing.

Alan Reynolds is a senior fellow with the Cato Institute.


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