Wednesday Weekly Update

This is the first of a weekly post that will expand on my Wednesday show with Jim Bresnahan of WREL radio in Lexington, Virginia

First, while I hate to start with the “fiscal cliff”, Jim Bresnehan as moderator asks the opening question. Given the amount of coverage it already receives, and that what will happen remains speculative, it’s hard to make a contribution. But let me ask whether it will really be a cliff.

One simple test is to examine the boom of the Bush years. Ah, there wasn’t one, was there? So if his tax cuts didn’t produce stimulus, then maybe reversing them won’t bring austerity. Make no mistake: we can look at Europe and see that austeriy, European-style, hurts. Maybe, however, the fiscal cliff represents less austerity than the hype would suggest. And as to hype, ask yourself whether those speaking of the need to avert the cliff also supported the 2009 stimulus package. If not, well, they shouldn’t be against a tax increase in January.

But at least some of the tax components don’t represent austerity, in particular taxes on capital income and (because that’s most of their income) the wealthy. The economics literature on investment — and remember that as an economist I mean the creation on new productive capacity and not trading pieces of paper on Wall Street — well, business fixed investment is simply not sensitive to interest rates. (That’s unlike household investment in new housing, because mortgage rates do matter.) Of course that suggests that a modest change in the corporate taxes doesn’t matter much, in the aggregate, because for small changes it operates much like an interest rate hike. And a tax on capital income is even more indirect and is offset by pension funds and other sources of finance that don’t pay taxes.

But we also have the Bush tax cuts as evidence. If undoing them will lead to a big drop in investment, their implementation should have led to a boom. So I looked at the data. The bottom line: there was no boom under Bush, though during the bubble period housing investment took off.

Other than during the bubble, neither was there a consumption boom — that makes sense, because overall employment growth was anemic. But that’s also consistent with the capital taxation story. Wealth is much less equally distributed than labor income: the wealthy are very wealthy indeed while almost half of our population has only modest assets. But high income individuals aren’t in percentage terms big spenders; instead they tend to save a lot. The middle class spend more. The lower half however are cash constrained, and tend to save very little, that is, they spend everything. So a cut to capital taxes doesn’t boost consumption — but does increase income inequality, which again we’ve seen.

In some for this first segment, for that portion of “fiscal cliff” measures, we don’t need to worry if no compromise is reached and tax rates revert to their pre-Bush levels.

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