THE SMITH CENTER

for Private Enterprise Studies

On Stimulating the Economy

by

Charles W. Baird

Emeritus Professor of Economics and Former Director of the Smith Center
California State University, East Bay, CA 94542

On November 26 the National Bureau of Economic Research, the private organization that gets to pick the dates for the beginnings and endings of recessions, said that the U.S. economy has been in a recession since March of this year. Actually the rate of growth of the economy had been slowing down for most of the year, and the terrorist attacks on September 11 exacerbated the slowdown. Journalists, politicians, and economists have been discussing ways of stimulating the economy for many months, and much of the discussion has been nonsense.

Early in the year Congress passed a $300 income tax rebate for each individual who paid income taxes on their 2000 tax returns. Politicians appealed to the recipients of the rebates to spend the money rather than save it, because the spending, they alleged, would stimulate the economy. Actually, whether the recipients spent or saved the money the effect on the economy would have been the same- zero. Why? Because tax rebates cannot add any new spending to the economy, no matter what people do with them.

Rebates mean that the recipients have more money to use for their own purposes, but the government has less money. Either the government must spend less or borrow more. If it borrows more, the people who lend the money to the government will have less to use for their own purposes. In either case there will be less spending to go against the additional spending on the part of the recipients of the rebates.

If the recipients save the tax rebates, the rebates will still be spent. People save money by depositing it in bank accounts or by buying financial securities and mutual funds. The banks that receive deposits from refund recipients then have more money to lend to borrowers (both households and businesses) who will spend it for their purposes. The people and firms who sell securities to other refund recipients will have more money to spend. The mutual funds that receive money from still other refund recipients will have more money to invest in enterprises. In short, saving is spending just as consumption is spending. The only difference is on what the money gets spent. Total spending in dollar terms is unaffected.

Real economic growth and prosperity do not, cannot, come from simply changing the agents, whether governments or private citizens, who are spending the money that is in circulation. Real growth and prosperity comes from the creation of new jobs, producing new and improved goods and services, for increasing numbers of people. This can occur even when the total amount of money in circulation declines. Money prices of goods and services would decline, but the actual quantity of goods and services enjoyed by people could continue to expand if the incentives faced by entrepreneurs, capitalists, and workers caused them to increase their productive activity.

The only role that tax policy can play in economic growth and prosperity is through incentives. If tax policy gets the incentives right, the economy will grow. If tax policy, instead, discourages productive activity, the economy will slip into recession. One way Congress could have a positive effect on the economy at the moment would be to make all of the cuts in marginal tax rates that were passed earlier this year effective immediately, and to eliminate the capital gains tax altogether. People do not change their current production, investment and exchange plans for the future because they get a refund of some of the taxes they paid on their past production, investment and exchange activities. When cuts in marginal tax rates are enacted in the present but do not take place until the future, people are likely to make plans for expanded productive activities when the tax cuts take effect rather than increase their productive activities in the still-high-tax present. Entrepreneurs are more willing to bear the risks of creating new enterprises if they are confident they can keep any increases in the market value of the assets they create than if they expect government to confiscate much of those gains. Entrepreneurs pay ordinary income taxes on their productive activities. To tax their capital gains as well amounts to double taxation.

Another way to understand these points is to recognize that demand (spending in all its forms) depends on production. It is productive activity that yields incomes (profits, interest, rents, and wages and salaries) which people than have to use for their diverse purposes. For example, the production of automobiles creates incomes for all the people involved in that production who then use their incomes to buy the various goods and services, including cars, that they are interested in acquiring. The production of any product or service creates incomes to be spent on cars as well other goods and services. Production is the source of demand.

The actual dollar amounts of the incomes don't matter. Lower dollar incomes can actually be higher real incomes if the dollar prices of goods and services are, on average, falling. Higher dollar incomes can actually be lower real incomes if the dollar prices of goods and services are, on average, rising faster than those dollar incomes.

What happens to the average of the prices of goods and services depends on the amount of money that the Federal Reserve creates in circulation. Government fiscal policy (spending and taxing) only shifts around how and by whom the money in circulation is spent, it does not create or extinguish money to be spent. Government fiscal policy does, however, affect the amount of real productive activity that goes on in an economy through its effects on the incentives people face. So far this year the federal government has done almost nothing to improve those incentives. Most of what politicians say today about stimulating the economy is murderously dangerous nonsense.