Tax Cuts or Spending Increases?

Given the economic situation that the Bush administration has left for president-elect Obama, everyone agrees that stimulus is needed. Congress has already passed the $700 billion bailout of the financial services industry, and we have gotten zero benefit from that so far because the administration has treated it as a corporate handout program rather than a stimulus program for the country. Thankfully, the last $350 billion or so from that program will be spent and monitored by the Obama administration, and I still have some hope that taxpayers will be made whole for that program through the equity and repayment mechanisms that congress inserted.

The next stimulus, as structured by the Obama administration, is divided between middle-class tax cuts and increased spending on infrastructure. I heavily lean toward the Keynesian model over the much-hyped economic theory of Milton Friedman, which still holds sway among conservatives and some moderates.

The Keynesian model was used in FDR's response to the Great Depression--which had been underway for three years when he took office. Keynes, however, would have advocated much more aggressive goverment action than Roosevelt tried, and he would not have slashed the programs so soon. (After four years of very good economic growth, Roosevelt slashed programs in 1937, triggering another recession.)

FDR's response to the Great Depression was largely successful, despite an enormous effort by conservatives to discredit it for the past 75 years. The conservative narrative--which has been largely adopted by the corporate media and has been taught as fact in public schools for 30 years--is that FDR's policies resulted in 13 years of stagnant growth and that it was World War II that pulled us out of the Depression. The fact is that GDP skyrocketed and unemployment steadily declined under Roosevelt--with a small blip in 1937 when he departed from the Keynesian model. Here is a chart of GDP:




Unemployment was a tougher nut to crack, arguably because FDR was less aggressive than he could have been during his first term at job-creation programs. In the wake of the 1937 downturn, he dramatically increased WPA funding, which finally began to break the unemployment cycle. I would argue that the institution of the minimum wage in 1938 was anothe factor in the reduction in unemployment. As seen in the following unemployment figures from the Bureau of Labor Statistics, FDR's administration realized a 14-point reduction in the unemployment rate prior to the beginning of World War II:

• 1923-29: 3.3%


• 1930: 8.9%


• 1931: 15.9%


• 1932: 23.6%


• 1933: 24.9% (FDR's first year in office)


• 1934: 21.7%


• 1935: 20.1%


• 1936: 17.0%


• 1937: 14.3%


• 1938: 19.0%


• 1939: 17.2%


• 1940: 14.6%


• 1941: 9.9% (last year before U.S. entry in WW II)

I would make note, by the way, that the Johnson administration changed the way that the unemployment rate is measured, removing those who had given up looking for a job and those who were in part-time work when they needed full-time work. By that measure, the December 2008 unemployment rate is 13.5 percent (you can calculate this at the BLS website by selecting the U-6 category). So we're getting close to 1931 levels, as would be expected in year two of an extreme economic downturn. Fortunately, we have a sane administration entering office now, rather than two years from now.

Anyway, back to the stimulus. By any measure, tax cuts on the wealthy provide the least stimulus of any expenditure of a government dollar. Fortunately, Obama is not proposing any of these. Middle-class tax cuts result in less stimulus than infrastructure spending, because consumers use a large portion of their tax cuts for savings and/or debt reduction from consumption already done. That said, low- and middle-income consumers are in need for cash for the above purposes now, and this can bring good long-term strength if done with proper balance.

I would argue, with Pelosi and others in the Congress and against Obama's preliminary proposal, that the Bush tax cuts on the wealthy be repealed immediately, rather than being allowed to expire in 1-2 years. History has shown us that higher taxes on the wealthy results in sustained economic growth (for instance, in the late 1930s, 1950s, 1960s, and 1990s), while tax cuts on the wealthy result in a boom-bust cycle that hurts the economy in the long term (1970s, 1980s and 2000s). This would provide revenue to partially offset the other tax cuts (reducing the impact on the national debt) and provide economic stimulus at the same time. For now, I'd raise the top tax rate to 39.6 percent--where it stood during the Clinton boom--and raise it further in a few years. The higher the taxes on the wealthy, the more likely they are to put revenue back into their businesses rather than taking it as profit. This increases the value of the businesses, reduces unemployment, and generally strengthens the economy.

The disadvantage that Obama has that FDR did not have is that the national debt before the economic bailouts is 70 percent of GDP--largely the result of profligate spending and tax-cutting by Republican administrations. So the caveat to the stimulus package is that someone needs to lend us the money. I expect the dollar to lose a lot of value over the next several years.