Philadelphia Reflections

The musings of a physician who has served the community for over six decades

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Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.

Making Money (3)

David Altman

Daniel Altman draws attention in the January 1, 2006 New York Times to Ben Page's estimation of compensating rises in federal tax revenue after tax cuts. Page (for the Congressional Budget Office) says revenue increases will only offset 28% of tax loss. The Laffer theory (that tax cuts pay for themselves) may be overstated but it's kind of right. Not only is the full amount of the tax reduction immediately released to the private sector, but only 72% of it ever needs to be borrowed and repaid. Tax cuts may not pay for themselves but they fully stimulate the economy immediately; 28% of the stimulus is permanent.

Mr. Altman then comments taxes could never be cut to zero, because lenders would then refuse to lend; surely no one disagrees. But it's extreme to say tax rates must currently be at a point "on the curve" where reducing them further will not generate a worth-while gain in tax revenue to be effectively re-injected back into the economy. All of any tax cut is always a windfall for the private sector; that's its purpose. Ben Page just says that only 72% of this one needs to be borrowed; the other 28% is a permanent cost-free saving for everybody. If you chose to stimulate the economy by increased government spending, all of that would have to be borrowed, all of it would have to be repaid.

But cheers for Mr. Altman, who notices the role of lenders, who place limits on how far you can stretch this idea. You can't cut taxes to zero because lenders won't lend to a government without income. And even as taxes approach zero, lenders will raise interest rates. That gets us to the currently inverted yield curve; why aren't long-term bonds able to command higher interest rates? If they rose, the interest cost would eventually wipe out the free ride for tax cuts.

Well, the big artificiality in this Calder mobile is the fixed exchange rate for Chinese currency. The Chinese are inexperienced, rightly fearing chaos if they allow their currency to float upward against the dollar. When they solve their problem, unless God helps us they bungle it, American bond rates will tell us whether it's safe to cut taxes some more. Interest rates on American long-term bonds will rise, perhaps too uncomfortably high levels. At that point, no government -- R or D -- would cut taxes further.

Originally published: Thursday, June 22, 2006; most-recently modified: Thursday, May 23, 2019