Friday, June 4, 2010

Why tax cuts are still not the remedy?

Nomura economist, Richard Koo had argued that currently we are passing through a "balance sheet deflation", wherein businesses and households have battered balance sheets which can be repaired only with fiscal policy (especially when monetary policy has lost traction). The magnitude of this cycle has been amplified by the fact that majority of the balance sheets were inflated by the valuations of assets which were in the first instancee purchased with unsustainable levels of debt. Once the bubble burst and the balance sheets exploded, forcing margin calls, defaults started, thereby amplifying the problem manifold.

Mark Thoma argues that in "balance sheet recessions" like the current one - where household (and business) balance sheets have been devastated by plunging asset (equity and homes) values - tax cuts can play an important role in repairing household balance sheets. This assumes importance in view of the fact that household spending, which is fundamental towards boosting aggregate demand, will get back to normal only when the debt holes in household balance sheets are refilled.

Ultimately, as Econ 101 teaches us, economic growth has to come by way of increased aggregate demand. For this to happen, repaired balance sheets help in so far as it encourages consumers to spend and businesses to invest. However, this indirect approach comes up against some pitfalls.

Taking households alone, the two major sources of balance sheet crisis are those arising from plunging asset values (and resultant "income-loss effect" which stunts consumption expenditure and causes a rise in effective mortgage values) and unemployment generated through lay-offs.

In the present case, the damage inflicted on balance sheets through the sub-prime meltdown and declines in asset values are too large, a few trillions of dollars, to be compensated with a few billions of dollars of tax cuts. For sure, these tax cuts, if properly targeted, will go into repairing balance sheets. But its impact is not likely to be much, unless it is relying on a vain hope that asset prices and market confidence will rebound adequately and in quick time and thereby repair the balance sheets. In the circumstances, one-off tax cuts, like the Bush tax rebate of Spring of 2008, will end up getting saved (and/or repay debts) and making limted impact on consumption.

Further, the damage caused by the largest post-war increase in unemployment rate cannot be repaired in any meaningful manner with one-off tax cuts. It can be argued that unemployment insurance is itself a form of targeted monthly/weekly income tax credit. However, as economists like Paul Krugman have been arguing, it is impossible to provide any significant boost to aggregate demand on a sustainable basis without quickly bringing down the record unemployment rates. Unfortunately, as Brad DeLong recently pointed out, unemployment appears far removed from the concerns of policymakers in the US.

It is in this context that the role of the multiplier assumes significance. Assuming a large enough multiplier for direct government spending, especially during recessions with the macroeconomic environment like now (and there is a very large and growing body of research to add credence to this claim), the arguement against tax cuts gains strength.

The other important objection against supply-side policies like tax cuts comes from the current macroeconomic environment. Despite widely expressed fears of impending inflationary spiral, all major indicators appears to inform that it is deflation and not inflation that should be the cause for concern for policymakers.

A cursory reading of the classic AS-AD curve indicates that when the supply increases without a commensurate increase in the AD (and from the aforementioned evidences, especially at a time like now, it is most likely that a major share of the tax cuts will not go into increasing AD), the prices will fall. In other words, tax cuts in a depressed economic environment like now, are likely to generate deflationary pressures.

In the final analysis, given the precarious fiscal position in most advanced economies, the priority should be on funneling resources into policies that deliver the greatest bang for the buck. In an ideal world, where resources are plentiful, all instruments of fiscal policy - tax cuts, infrastructure spending, and welfare measures - should be deployed.

However, when faced with a macroeconomic environment like now, policies than can directly boost the aggregate demand and generate plus-one multiplier are surely more attractive than ones that work their way slowly by repairing household and firm balance sheets. Moreover, policy makers should hope that they get a helping hand in repairing the balance sheets from the continuing expansionary monetary policy and a resurgence in the asset markets.

No comments: