Three Views of the ‘Fiscal Cliff’ by Edward Paul Lazear

Discussion of the so-called fiscal cliff—the combination of tax increases and spending cuts that will come in 2013 if Congress and the president don’t act—confuses a number of different issues. The evidence suggests that we should fear the tax hikes, but not necessarily the spending cuts.

Anyone who uses the term “fiscal cliff” accepts a Keynesian view of the economy, knowingly or not. Both tax increases and constrained spending are assumed to be bad for the economy.

But there are two other views: that of the budget balancer and that of the supply-sider. Rather than term the impending changes that will occur in 2013 a “fiscal cliff,” the budget balancer thinks of this as “fiscal consolidation.” Tax increases reduce the deficit, as do cuts in government spending. Both are austerity measures that make the government more responsible and, therefore, both are conducive to long-run economic growth.

Those who support the Simpson-Bowles plan subscribe, at least in part, to this view. Various proponents of the plan may place different weights on the tax-increase side or the spending-decrease side because they believe the economic consequence of one or the other is more adverse. But fundamentally, the target is to decrease the deficit. The budget balancer regards both tax increases and spending cuts as moves in the right direction.

The supply-sider has a different view from both the Keynesian and the budget balancer. Fundamentally, supply-side advocates focus on the harmful effects of tax increases. Raising tax rates hurts the economy directly because tax hikes reduce incentives to invest and because they punish hard work. As such, tax increases slow growth. But budget cuts work in the right direction by making lower tax revenues sustainable. If spending exceeds revenues, then the government must borrow and this commits future governments to raising taxes in order to service the debt.

Consequently, the supply-sider thinks of 2013 primarily as a tax increase and fears what that will do to the economy. The spending cuts are a positive.

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Mr. Lazear, chairman of the President’s Council of Economic Advisers from 2006-2009, is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.
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