Worst-case scenario: more debt-financed spending & higher tax rates

The Obama administration continues to listen to bad advice on how to set conditions for an economic recovery. It seems likely that there will be a significant increase in the tax burden by allowing the Bush tax cuts expire & the ruinous path of deficit-financed government spending will continue.

While deficit-financed government spending is unlikely to boost economic growth in the short run, higher government debt-to-GDP ratios impose significant long-term drag on the economy. As it is, individuals are likely to spread increases in consumption over many years or anticipate higher future taxes necessary to repay larger public-sector debts. As such, deficit-financed fiscal expansions, whether on shovel-ready physical infrastructure or pork, tend to crowd out the private sector and are unlikely to raise output.

It turns out that spending CUTS are more likely to have beneficial impacts since they reduce deficits and debt-to-GDP ratios. The best historical evidence of this is that government spending after WWII dropped nearly 60%. After that, the US economy went into overdrive with a long-lasting, self-sustaining boom!

Tax cuts are much likelier to increase growth than more government spending. For their part, tax cuts by Reagan in 1981-83 and George W. Bush’s in 2003 that both involved lower marginal tax rates led to higher economic growth.

For their part, best-case, tooth-fairy estimates of government spending multipliers of about 1.5 whereby $1 of new government spending supposedly leads to a rise in GDP of $1.50. (The impact of the current “stimulus” spending contradicts this rosy scenario, as does a considerable amount of theory.)

Meanwhile, estimates for tax-cut multipliers are from 3.0 up to 5.0, suggesting that reducing the tax burden by $1 will boost GDP by $3 to $5. And increasing the tax burden will tend to move GDP down by similar proportions.

For their part, the Obama team seems determined to follow an economic policy mix that is the opposite of what could lead to a sustainable economic recovery.

A better course of action would be to decrease marginal corporate & personal tax rates while phasing down government spending.

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About christopher

Content of "Natural Order" attempts to reflect the commitment of Universidad Francisco Marroquin to support the development of a society of free & responsible individuals. The principal commentator for this blog is Christopher Lingle.

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