The issue for this week is tax policy. This issue is needlessly complicated, and accurate analysis, like education policy, requires a series of articles. In Part I, I will discuss the crowding out effect which explains the danger of unguarded deficits. Part II will explain the effect of spending on local projects which have no national significance (pork-barrell spending). Part III will focus on some of the taxes that are debated, and where the candidates stand. Finally, Part IV will explain the different alleged effects of these positions.
There is a threshold issue of whether the increase in spending has any effect on demand. Neoclassical economists argue it does not. Whether someone chooses to pay a dollar in tax today, or their decedents pay a dollar in tax with interest in the future, makes no difference. Alternately, others believe that increased spending of a dollar results in demand increasing by more than a dollar because that dollar will be spent and respent throughout the economy vastly increasing demand. In a broad sense, the crowding out effect asserts that rewards have hidden costs that will actually reduce intrinsic incentives to perform an action. Paying a friend for coming over for dinner will reduce the value of the friendship.
There is a money market in each country with currency, the total amount of money is the combination of currency and assets that can be easily converted into currency. This amount is tracked by the Federal Reserve on a weekly basis. When the government borrows money there is less money available for private use, and increased scarcity. That scarcity can cause an increase in interest rates. Whatever the interest rate, the government can always pay to borrow money. However, at some point private institutions will no longer be able to borrow money. At that point, they are crowded out of the market.
This raises the question of whether raising taxes to cover the increased spending is better than increasing the debt (one of this must increase).
The contemporaneous issue is which position has greater merit. Prof. Spector concludes:
[E]ven in the best of econometric conditions, resolving the crowding out/Ricardian equivalence controversy will require researchers to have a more complete understanding of the structural relationships that underlie macroeconomic models.
So, there you have it, the jury is still out on the issue. Both views play an important role in policy as I shall explain in the coming days.