New Macroeconomics: Same As Old Macroeconomics

Alex's post below cited Sachs' op-ed, which is essentially a re-iteration of traditional Keynesianism. He proposes a gradual tax increase, but only on the rich, in order to increase the government's share of the pie. In his view, this will allow us to balance the budget, massively increase foreign aid, massively increase infrastructure investment, shore up the safety net, and reduce income inequality. Sounds great.

The only problem is that making the tax code more progressive has diminishing returns. Two things happen as you focus more and more tax incidence on a smaller and smaller number of people: those people find ways to opt out, and you become more susceptible to budget problems when a recession hits. This is especially true when the wealthy are disproportionately located in one sector of the economy, and the recession is focused on that sector. When the incomes of the top earners decline, then government revenues decline as well. This, of course, is the situation we presently find ourselves in: the wealthy are disproportionately located in the service sector, which has borne the brunt of the current contraction. Their incomes are dropping, so tax revenues are dropping.

A case study is illustrative. Public works in New York City have long been financed largely by the financial industry, and the outlook for the City is not good: they are being forced to cut public services in response to the financial crisis. Property values are down, which means property tax receipts are down. NYC put their eggs in the financial industry's basket, and now they are feeling the pain. Of course we see the same across the country; universities are cutting budgets, state and local governments are slashing spending to balance budgets.

If you give tax cuts and/or other stimulus to the middle class, as Obama has proposed and Sachs supports, then at best an increased tax on the upper class will be revenue neutral. But it won't provide new money for more services. This is especially true in the U.S.'s current situation: massive budget deficits, declining revenue, and growing entitlement responsibilities will make it impossible to increase public services without broadly increasing the tax burden on the whole polity. Something's got to give: either taxes go up for a larger part of the population than Obama and Sachs have proposed, or some programs will have to be cut or abandoned. (My guess? The first initiatives to be cast aside will be increased foreign aid, environmental programs, and universal health care.)

Sachs is a Keynesian, so calling for countercyclical fiscal policy is expected from him. But in order to be successful, countercyclical policies have to be pursued in expansions as well as contractions. That means increased spending now, but a tightening of the fiscal belt when the economy turns around. Sachs (and many other economists) have criticized the Bush tax cuts and fiscal expansionism of the past few years along these lines, and rightly so. But will they be similarly critical of President Obama if he doesn't scale back government expenditures after the economy recovers?