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Not from the Onion

Summary:
In the 1990s, this sort of Bloomberg headline would be assumed to be a spoof from The Onion: Taxing the Rich to Fund Welfare Is the Nobel Winner’s Growth Mantra Just because it seems whacky doesn’t mean it’s wrong. My views on the Great Recession (tight money caused it) are also widely viewed as being whacky. But in this case, the Nobel Prize winner’s views are wrong for two reasons. Abhijit Banerjee recommends higher taxes on investment, with the money redistributed to lower income people. The argument is that the rich have a lower propensity to spend and hence redistribution to the poor will boost aggregate demand. One obvious problem is that the Fed will engage in monetary offset, either raising interest rates or cutting them less rapidly, and hence

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In the 1990s, this sort of Bloomberg headline would be assumed to be a spoof from The Onion:

Taxing the Rich to Fund Welfare Is the Nobel Winner’s Growth Mantra

Just because it seems whacky doesn’t mean it’s wrong. My views on the Great Recession (tight money caused it) are also widely viewed as being whacky. But in this case, the Nobel Prize winner’s views are wrong for two reasons.

Abhijit Banerjee recommends higher taxes on investment, with the money redistributed to lower income people. The argument is that the rich have a lower propensity to spend and hence redistribution to the poor will boost aggregate demand.

One obvious problem is that the Fed will engage in monetary offset, either raising interest rates or cutting them less rapidly, and hence there will be no impact on aggregate demand. This is true even if the Fed is consistently undershooting its 2% inflation target by a few tenths of a percent, due to over-reliance on Phillips curve models.

But even if the Fed does not adjust interest rates in response, the policy is likely to fail. It’s a mistake to focus only on the different marginal propensities to spend. A tax on investment will depress the propensity to investment, and this will reduce the equilibrium interest rate. So even if the Fed keeps interest rates constant, money will become effectively tighter. Indeed we’ve seen something like this over the past 12 months, albeit due to the trade war, not higher taxes on investment. And the opposite occurred during 2017-18, when lower corporate taxes boosted business investment demand and raised the equilibrium interest rate.

Banerjee is relying on a model that Paul Krugman used to call “vulgar Keynesianism”. It’s just as wrong today as it was in the late 1990s.

PS. I’m not suggesting that redistribution is a bad idea; progressive consumption taxes and low wage subsidies have a lot of merit.

HT: Michael Darda


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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