Wednesday, January 24, 2018

Republican Tax Reform: Part 6 —Keynesian Thinking (About the Demand Side) and Distortions (Mostly About the Supply Side)

To many Republicans, and to some voters in Utah, “Keynesian” is like a swear word. They associate it with big government, generous welfare policies, and so on.

Here’s the thing: Keynes’ ideas about macroeconomics underpin a lot of Republican policy ideas. They just won’t admit it.


Any time we talk about taxes and macroeconomics, we have to think about two different dimensions of the issue: tax revenue and tax rates.

Governments plan for tax revenue, but they can’t control it very well. Why not? Mostly because the economy is hit by many shocks, and tax rate changes are just one of them. You might have a good forecast of what your tax rate change is going to do, but the other things going on might swamp that.

Governments control tax rates, but it’s often hard to connect those to how the economy behaves because they affect it through both tax revenue and tax distortions.

It’s hard to connect tax revenue to how the economy behaves too, but at least you can use your estimate of it to plan your spending budget as well.


The public doesn’t always make that distinction very well. Republicans are expected to be more likely to “cut taxes”. But what exactly does that mean? (And there’s no reason you can’t insert some other political party, like Democrats wherever I write Republican).

What a Republican politician can do is cut tax rates. They could also eliminate a certain tax, but if you think about it, that’s just cutting the tax rate to zero percent. So any difference is one of scale.

Another thing a Republican can do is narrow the tax base. The tax base is the group of people or firms, or the portions of their income or wealth, that are subject to a tax. There’s really no difference between this and cutting tax rates either: there’s no difference between paying a 20% tax on 10% of your income and paying a 10% tax on 20% of your income.

It’s a little off-topic, but I’ve talked about how the reform of 1986 was a big one. A major thing that they did was eliminate loopholes and other forms of tax favoritism across a broad range of taxes. This allowed them to lower rates generally because they’d made the base so much broader.

Anyway, what voters want mostly is their tax bill to be cut. So this can be done by cutting rates, broadening the base (so everyone pays less), or exempting some income (creating a loophole). But however the Republicans choose to do this, what they’re hoping is that the forecasts they make of how much people will pay will go down.


Keynes’ theory focused on spending. More spending and the economy boomed, less spending and it faltered.

Keynes worried about what we might today call consumer confidence or consumer sentiment, but which he called animal spirits, and which some books call herd behavior. Basically it means that a society as a whole can go through extended waves of optimism and pessimism. In the former, we spend more because some of it is on stupid stuff because we’re having such a good time of it. In the latter we spend less, and we may not spend enough on useful stuff because we feel lousy about the whole world. This is where he thought business cycles came from.

Macroeconomists have backed off both of those Keynesian stories. Some have eliminated them completely, but for most of us we think they’re still in the mix, although maybe not the biggest part. But politicians have not backed off those views much at all, so the Keynesian view is a great way to understand what politicians do, even if it leaves some parts of the macroeconomy unaddressed.

Keynes also asserted that government should pursue countercyclical policies. This means that when the public is optimistic and spending too much, the government should back off a little bit. And when the public is pessimistic, the government should step up its efforts.

For Keynes and Keynesians, changes in government spending were seen as more effective than changes in tax revenue. For example, if they needed to boost the economy the government could spend more and be certain that it happened. But if they tried to do the same by cutting tax revenue, people might just put it in the bank and spending wouldn’t change.

In the U.S., the Democrats were the majority party when Keynes’ theory was ascendant. So they adopted government spending as their primary tool, and tax changes as a secondary one. The Republicans reversed that: they claimed taxes as their baby, and spending as the afterthought.

Remember up above when I said that Republicans today view Keynesian as a sort of swear word? That’s dumb, because their position that they can manage the economy primarily through tax changes is Keynesian through and through. But … whatever … they’re just words and people will use them any way they like.

And when the Republican constituents clamor for a tax cut, what the Republicans attempt to give them is a cut in tax revenue, but they do this through cuts in tax rates.


This brings us to distortions. A problem running behind all of this is that all taxes imposed as rates (instead of flat fees) are distortionary. This means they induce some people to do something they ordinarily would not.

All that stuff in your micro class about deadweight loss is about distortions. Without a tax, the market mechanism impersonally divides up potential buyers into two groups: those that choose to buy and those that don’t. It does the same to suppliers. What happens with a tax, and is behind the deadweight loss, is that the division is now into 3 groups: those that still buy, those that still won’t buy, and those that switched from buying to not buying because of the tax (3 groups for sellers too).

When we talk about the tax code getting more complex, what we’re really talking about is the number and scope of distortions increasing, creating additional problems when they overlap or interact with each other.

The Laffer Curve is an example of a really bad distortion. This is the idea that if a tax rate is high enough, it may distort behavior so badly that cutting it may actually raise revenue. Unfortunately for Republicans, there’s a much deeper belief in how common this effect is than is borne out by the data. Most of the time, you can safely dismiss this possibility as just a theoretical curiosity.

Generally, we tend to think of distortions as mainly a supply side problem. This is because, for all we complain about our personal income taxes, they are nothing compared to the hoops that we make businesses jump through.

So, when we talk about a supply side approach to tax reform (which the Reagan administration was known for, and whose crowning tax achievement was the reform of 1986) we mean a general reduction in the number of different rates, brackets, and exemptions, and a broadening of the tax base.


Putting it all together, this tax reform is mostly a Keynesian demand side reform. It’s done some things to cut rates that are likely to lead to cuts in revenue, and more ultimately more private spending.

It’s widely perceived that this Republican tax reform, on net, did nothing to improve the supply side and may have made it a little worse. Everything that’s in it comes with a distortionary backside: cut the corporate tax rate but distort that with a one time repatriation tax, increase the standard deduction but add a distortion by creating brackets for SALT deductions, cut the Obamacare penalty (less distortionary by itself) because the conservative base wanted that along with an increase in childcare credits (more distortionary).

1 comment:

  1. Just a note about Laffer curve effects in reality. These are exceptionally rare, and hugely overrated by conservatives. Possible? Yes. Likely? Almost never.

    But, we frequently see situations that are easily confused for Laffer curve effects. The interesting part of the Laffer curve is the part where reducing a (generally) high tax rate leads to an increase in tax revenue (because people reduce their tax avoidance). This is not the same as someone shifting when they pay their tax in response to a tax rate change. This happens a lot with taxes on assets that are paid periodically. We had a great example of this a few weeks ago. The Republican tax reform passed towards the end of December, and its limitation on SALT deductions would begin with the 2018 tax year. So what many people did was move forward the tax they'd pay in a year (and not be able to deduct). Instead, they paid it early to take advantage of the deduction still in place for 2017. Tax shifting is reasonable, but it is not a Laffer curve effect, because it is mostly about when you pay what you're not trying to avoid, rather than whether you pay differently because you avoid differently.