Tax-Cut Fallacies

March 9, 1964

The Administration’s pressure for the $11.5 billion tax cut just enacted may be cynically ascribed to an effort to win the coming election. But it is also supported by an economic theory, a theory now widely and sincerely held, that is set forth in some detail in the recent Economic Report of the Council of Economic Advisers.

It is a pure “demand” theory. It assumes that, whenever there is recession or unemployment, the reason must be “insufficient demand.” “Excessive unemployment is the most obvious symptom and one of the worst consequences of a level of demand that falls short of the nation’s potential output.”

Therefore, the report concludes, “the Federal government must adjust its programs to complement private demand. . . . The budget must counterbalance private demand.” “Inadequate” private demand “can be corrected either by expanding government purchases to employ idle resources . . . or by expanding private business and personal after-tax incomes through reduced tax rates.” In other words, the government can deliberately resort to deficits.

But this last word is still unpopular. It arouses distrust, so the council shies away from it. Instead, it invents a new concept—“the full-employment budget.” This is a purely hypothetical budget, with no relation to the real one. It is what the relation of government expenditures and revenues ought to have been, according to the council’s theory, to bring about full employment (or rather, to prevent unemployment from going above 4 percent).

DREAM-WORLD SURPLUS

Let’s see some of the consequences of this new concept. We have had 28 actual deficits in the last 34 years. But when we start talking of “full-employment budgets” most of these turn out to be “surpluses.” In the fourth quarter of 1963 the Treasury was estimating the actual deficit at a rate of $9 billion a year, but it turns out from the new calculations of the Council of Economic Advisers that at the time there was a “full-employment” surplus of $9 billion. In fact, by this new method of hypothetical figuring there couldn’t be a deficit in the “full-employment budget,” no matter what the actual figures showed, as long as there was any unemployment!

The fallacies in this theory should be clear. It is a stale Keynesianism. It takes it for granted that any “idle resources” or unemployment anywhere must be the result of “deficiency of aggregate demand.” By “demand” it means, of course, monetary demand. So this demand is to be increased either by more government spending or lower taxes, and the bigger deficit is to be paid for by printing more money—i.e., by inflation. “When aggregate demand is generally deficient and investment and consumption are expanding too slowly to provide jobs for all those seeking employment, expansionary monetary policy normally can and should accompany expansionary fiscal policy.”

DEMAND AND PRICE

Nowhere does the council recognize that “demand” is merely relative to price. When goods are priced too high some of them must remain unsold. When labor is priced too high some of it must remain unemployed. Unemployment is the result of maladjustment of wages and prices. Given wage-price coordination, supply creates its own demand.

The only way to cure unemployment is to permit, through free-market competition, the necessary adjustments and coordinations throughout the wage-price system, and to encourage saving, investment, and profits. As Keynes himself conceded in 1932: “There is no possible means of curing unemployment except by restoring to employers a proper margin of profit.”

Given workable wage-price relationships, full employment is possible without deficits and without inflation. But even huge deficits and inflation cannot bring full employment if wage rates are encouraged to rise faster than prices and productivity.

To cut taxes and increase our inflationary deficit may give us an overheated economy till election time, but it is a reckless and ominous policy for the longer future.