Do Keynesian or supply-side theories apply at the state level? That’s relevant right now. The national economy is slowing just as state legislatures are setting tax and spending levels. Should legislators consider how such decisions might alter total output, inflation or unemployment?
In fact, changes in any one state’s tax and spending levels do little, if anything, to alter short-run economic conditions within that state. However, these factors do influence a state’s long-term growth, income and employment. Moreover, if many of the 50 states act in the same direction at the same time, the collective outcome may affect national conditions, at least marginally. But attempts at control are futile.
The reasoning depends on what economic thinkers you find convincing. In 1936, John Maynard Keynes’ assertion that governments could and should speed up or slow down economies was revolutionary. Now it is accepted wisdom among politicians, the media and the general public, if not among economists.
When the problem is low output and high unemployment, Keynes said government should cut taxes and increase spending. It should boost the money supply to lower interest rates. This would spur both household consumption and business investment in new machines and facilities.
When an economy boomed and inflation prevailed, do the opposite. Raise taxes and cut spending. Crimp the money supply to boost interest rates.
The economy is slowing, at least a bit, right now. So the legislature ought to increase spending and cut taxes, right?
The answer is no for the simple reason that a state is not a nation. Keynes wrote when there were high barriers to economic flows even between nations. He could theorize about a situation where discretionary policies in one country affected no one else. In 2007, that is much less true for most nations than seven decades ago.
It is not true at all for states. The effects of tax and spending changes to boost Minnesota employment or output would not magically stop at the Wisconsin, Iowa or Dakota state lines. Some would flow as far as New York, California or Florida as well as Ontario and Manitoba.
Moreover, Minnesota does not have its own currency. It cannot increase or decrease the money supply to change interest rates the way the Federal Reserve can for the nation.
Indeed, economists now believe that with contemporary conditions of flexible exchange rates and capital flowing freely between nations, tax and spending changes at even the national level are ineffective in speeding or slowing an economy. Keynesian economists would tell states to forget about countering the business cycle.
What about other points of view? Supply-side economics is persuasive within the Bush administration and among Republicans, even though it convinces only a minority of economists.
True supply-siders are anti-Keynesians. They reject the whole idea of tromping on fiscal or monetary brake and gas pedals. This was what got us into trouble in the first place, they argue.
Taxes are important to them, as well as government regulation. Cut tax rates, especially high marginal income tax rates on wealthy people, they argue. Such people are most likely to invest any dollars freed from taxation. Increased investment spurs long-term growth of output and income. Spurring consumption to get out of short-term ruts would reduce investment. So don’t try to fiddle with short-term fluctuations.
True supply-siders did not like budget deficits. Indeed, these were seen as a particularly harmful result of Keynesian micromanagement. So they would not advocate a combination of tax cuts and spending increases to spur Minnesota’s economy right now.
This is not to say they would be neutral on this legislative session’s key questions. The DFL proposal to increase taxes on the rich is diametrically opposed to their recommendation. Better to tax consumption of all households by moving to a broad sales or value-added tax. More importantly, they would say, don’t spend money on myriad government programs of questionable effectiveness – like ethanol subsidies.
The wisdom of using state-level policies to smooth out short-run fluctuations in employment or business output is one place where Keynesian and supply-side economists would agree. It is a bad idea.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.