It Isn’t Brinkmanship

when you’re not standing on the brink. Karl Smith has published a very thought-provoking post in which he proposes a complete, temporary tax holiday:

So what happens if we simply suspend taxation for a few years and then pay it back later?

I know, I know there are issues about market freak out and the signals that such a move would create. Some will also object that such a move would alter interest rates based on sheer volume but I doubt that actually.

Even still lets put all that aside for the moment.

If the government suspends taxation and then tries to raise the money later to repay what it borrows it will actually be extracting less real resources from the economy.

Hat tip: Alex Knapp

Dr. Smith goes on to discuss interest rates, growth rates, and deadweight loss.

The reason I find this post interesting is that Dr. Smith has almost but not quite introduced a very new topic into the discussion of the economy and how to make it grow. He assumes that we will pay back the extra trillion or so per year that is the difference between what we’re raising in taxes and what we’re spending. Why?

We presently finance our government by a combination of taxes, borrowing, and currency expansion. What is the optimal mix? Does it change over time?

We have a fiat currency. Let’s assume, arguendo, that we are in a “liquidity trap”. That’s what any number of economists, notably Paul Krugman, have been saying for some time. A liquidity trap is a situation in which the sovereign is unable to debase the currency whatever it does. Given those circumstances, isn’t the best solution with the least deadweight loss to suspend taxation and finance the government solely via currency expansion? We could even pay down the debt a bit to improve our cashflow situation when conditions return to normal (if ever).

Horrifying, isn’t it? But is the suggestion wrong or right?

6 comments… add one
  • Icepick Link


    I think one of the commenters at the original post makes a good criticism:

    The multiplier would be awful: a majority of the work-force does not pay any federal income tax. Much of the tax comes from high earners, which in the current environment would save a significant portion of it.


    Thus purely from an economic point of view the best policy would be a payroll tax cut with a ceiling for the cut. This spreads most of the cuts towards the median household (where most of the potential demand is) instead of the average household skewed by one hundred bubble billionaires.

    Yet another risk of cutting taxes for high earners is that funds will simply flow out of the country and be invested in China and elsewhere – boosting their economies, not the US economy.

    I don’t think the idea that high income earners will save is necessarily bad, but if they decide to put their savings into high growth developing countries then all we will achieve is an even greater wealth concentration.

  • PD Shaw Link

    Icepick: I’m not sure why high earners would be more (or less) likely to send money to China than low earners (by consuming cheap Chinese products). It seems like the answer would lie in determining which economic group would most likely use the money to buy services?

    In any event, I had similar thoughts about the preferability of payroll tax, but it alone might be too oriented to low income earners because (1) for those who pay income taxes, its income, so for every $1,000 the payroll tax is cut, half of the country will be paying an additional $100 to $350 in income taxes, and (2) the SS portion of the payroll tax drops out at $106,800 in wages, which means a payroll tax cut may not offer much help to those in the top quintile of incomes that are overleveraged.

  • PD Shaw Link

    Where I’m kind of stuck on the Karl Smith proposal is what appears to be an assumption of somewhat permanent near-term low interest rates. If interest rates on 30-yr treasuries rise to say 2%, I would not be betting future U.S. growth will be higher.

  • Icepick Link

    PD, the lower income earners will send money to China via commerce – at least the shops they frequent will get some skim, or Amazon. However, if Warren Buffet were to spend more money on an oil project in Brazil (to pick people, projects and places at random), he would just another opportunity to make even more money in the long run. The point is, the consumer spends and the investor increases their wealth. Opposite directions.

  • Icepick Link

    Excuse me, I got a little sidelined from my original thought.

    Say some super rich dude decides to take his former taxes and “save” them. For the rich that means investing. So far so good. If said dude were to invest in some enterprise in America, that has the chance to benefit not only him, but the Americans who might be employed by that project either directly or indirectly.

    OTOH, investing in a BRIC, seeking a higher rate of return perhaps, has the chance to accrue benefit to said dude with much less chance of it helping the American economy directly, or American workers. This second scenario provides more room for a widening wealth gap than the first scenario.

    In that case the nation has suffered a fair amount by not taxing that guy, as a good deal of the benefit would go to some other nation entirely.

  • Maxwell James Link

    Regarding the criticism Icepick brought up – one potential alternative would be to suspend all state-level sales & income taxes for a year or two, and have the feds make up the difference with grants to the states (in turn likely fueled through QE).

    I don’t particularly like the idea, and think the coordination issues would be huge, but it would put quite a bit of money back into the hands of low-to-medium wage earners.

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