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Saturday, Aug 25 2012 10:00 PM

3 myths that limit economy's ability to recover

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    Greg McGiffney

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The underlying economic theory as to why the private sector has not recovered from the last economic downturn is not well understood by many people, with some of the so-called experts in this area (Paul Krugman, et al.) saying little more than government is not doing enough to intervene. But the reason for the stagnation is actually due to three prevailing myths about economics that have been perpetuated by these same "experts." Thus, refuting these myths in some detail should shed some light as to why economic growth and business confidence has been lagging.

Myth No. 1: All "tax cuts" must be "paid for" somehow. First of all, when "tax cuts" are mentioned, that usually means a reduction in a specific marginal tax rate. There is a misguided fundamental assumption that in order for the government to attain more tax revenue, marginal tax rates must increase. But this is wrong due to the concept of diminishing returns.

For instance, if someone charges too much for a commodity, customers will tend to buy less of it, and the overall sales revenue for that commodity for that merchant will not be maximized. However, if the same merchant reduces the sale price of that commodity, the merchant will sell more. In fact, once the merchant reduces the sales price of that commodity to the right level, the optimum level of sales revenue will be attained. Price impacts behavior. The economist Arthur Laffer demonstrated this (the Laffer Curve) by showing that if an economy is overtaxed, reductions in marginal tax rates would eventually optimize government revenue -- as there would be incentive for taxpayers to improve upon their after-tax income. This adds to economic growth, which further improves tax revenue collection.

Taxation also impacts behavior. In fact, every time we have reduced marginal tax rates (Presidents Kennedy, Reagan and George W. Bush all shepherded reductions in marginal tax rates during their administrations) tax revenue has increased significantly. So, the premise that we must always somehow "pay for" reductions in marginal tax rates is flawed in that these reductions are essentially improving the growth of revenue the government would otherwise have had the rates not been changed. Ironically enough, tax cuts that are denigrated as part of a "trickle down" that supposedly do not work are actually proven to be a part of a "trickle up" to the government in terms of tax revenue.

Myth No. 2: Increased government spending can create permanent sustainable jobs that reduce the level of structural unemployment. A hallmark of the economic theories espoused by J.M. Keynes is that during an economic downturn, government should spend (even borrow) to create jobs. To him, it did not matter what kind of job was created, as long as it got wages into the economy, reducing the rate of unemployment. Eventually, he theorized, the private sector would absorb these jobs, alleviating structural unemployment, and the need for deficit spending would diminish. With enough private-sector employment in place, government would eventually leave the labor market, and the government would eventually attain a surplus of tax revenue, with more private-sector laborers paying taxes without the burden of keeping them on the government payroll.

However, this theory has never really worked out as designed. When government tries to stimulate economic growth (such as ARRA), the jobs do not immediately come into fruition, and those that do are of a temporary nature. One cannot build the same road indefinitely, for instance. More recently, the federal government has tried to create economic stimulus by increasing the federal workforce and funding more state and local government jobs. This has not translated to an appreciable reduction in the overall rate of unemployment, particularly private-sector unemployment. This in turn has not improved the overall growth in tax revenue, and still more deficit spending is needed to keep these jobs in place so as not to add to economic calamity. Keynes was correct in that private-sector job growth is the solution to improving the economy -- but adding more government jobs is not necessarily the answer to improving structural unemployment. The public payroll becomes a drain on an economy when the private sector can no longer sustain it.

Myth No. 3: Stimulus spending by the government promotes sustainable economic growth. Another way in which the government can supposedly aid an ailing economy is to spend more on everything. The government could target certain technologies for funding by the government to encourage new sectors to grow, even if there is no economic basis or market for such funding to keep it sustainable. The government could also prop up certain companies that are struggling, and also back banks that have investments that are failing (i.e., subsidize "bad debt"). Regardless, governments could either issue bonds to pay for the debt incurred to implement such programs, or in the case of the federal government use deficit spending to fund such programs -- with the idea that future economic growth (as noted by an expanding GDP) would cover these debt payments.

But why is this idea a fallacy? While certainly government spending is contributory to GDP growth, it is also based upon the need for taxes to support such spending, which reduces GDP growth, as taxation takes money out of the economy. To wit, if the government desires to spend more than it takes in, it must borrow the difference. However, there is a limit to the amount of debt which government can keep piling up year after year. At some point, the cumulative debt must be paid by the taxpayer. Now when the economy grows, enough revenue typically comes in to cover the added debt payment. But if the economy slows and government cannot meet its debt payment schedule due to tax revenue coming in below projection, default or bankruptcy can result (see Stockton and San Bernardino).

Essentially, taxation changes human behavior, which influences economic activity. The economist David Ricardo explained it like this: When people expect to be required to pay for something in the future, they will know that they will be able to pay for it then by allocating some of their current resources for that purpose. With higher taxation being anticipated by most individuals and businesses, this restricts the growth of the economy today, as money that would otherwise go into today's economy would be held out in anticipation of future obligations. Milton Friedman's assertion that government spending is actually taxation is fundamentally correct -- spending cannot go forward ad infinitum without it. Without a doubt there is a point by which a currency can be destabilized by unrepentant borrowing and spending. Unsustainable government spending caused the fall of the Weimar Republic (leading to World War II) and is causing crisis with the euro (in particular, Greece). Likewise, demonizing restraint in government spending, by calling it "austerity" that will cause doom on the economy, is a specious argument. For this restraint lifts a burden off the taxpayer and allows for greater investment and participation in the economy. Once government can get its spending priorities and plans in order (including entitlements), it becomes more likely that markets and the private sector will respond favorably to invest and grow. Until that occurs we can expect continued economic uncertainty.

Greg McGiffney is a Bakersfield businessman, adjunct college professor and captain in the U.S. Navy Reserve.

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