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Homegrown fiscal policy model tackles tax reform scenarios

The tax bills have not won high marks from economists or observers in the press.
Speaking at the broadest level, the concerns relate to fairness and aggregate impacts on debts, deficits, and growth:
1. The bill is mostly bad for the poor and middle classes and benefits the well-off unfairly.
2. While pro-growth effects are at best greatly exaggerated and effects on deficits underestimated by the Republican team, I see excessive concern in general with deficit levels. A normally functioning national government with a floating exchange rate and almost no debt in foreign currency has no real constraint on spending, other than possible ill macroeconomic effects (inflation, etc.) when amounts are badly chosen. Here is some model output that shows fluctuating spending in response to instability generated in private sector investment spending.


First, I show above a version starting from two different sets of starting points. For each set, three lines—representing the growth rate of the public spending, the stock of capital, and capacity utilization eventually fluctuate regularly but do not explode. The plot that rises on trend with regular downturns is government debt divided by the capital stock.

Second, in the figure above I start the model from a randomly selected set of points, and find that my results do not depend sensitively on my choice of starting points for the four variables. A related diagram at the top of the post shows two-dimensional dynamics of an inward spiral of gradually stabilizing public spending and capacity utilization.

The model is described a bit on this page of this site. I have used a version that tracks government debt generated by spending decisions.

Why is this necessary in the model—or in reality? (1) People and financial institutions with money to invest wish to accumulate the safe Treasury securities issued as the government spends. They constitute a safe investment in a manifestly risky world.

(2) The government is the only sector that can offset instability in investment by firms, as its job is to stabilize in the aggregate (in behalf of the public) and it alone has the means to do so.

The model has not been carefully calibrated but illustrates what one finds with a range of reasonable assumptions in a similar model. I have tuned the model so that fluctuations happen and are visible on the page. (Wonky note: They happen because of a nonlinearity in the model of investment by firms.) It is based on assumptions consistent with Modern Monetary Theory (MMT). Tom Palley, an MMT critic (and contemporary-great labor-oriented Keynesian), has in contrast found unstable results by trying to combine some real MMT ideas with exogenous (determined by policy) government money–not really so MMT and not so real-world. (Links to two of these papers at Palley’s website are here and here.)

The disadvantages of major deficit increases alleged by mainstreamers on the left and right—say, the New York Times and perhaps everyone in the Democratic caucus in the U.S. Senate—include a “crowding out effect,” whereby the government drives up interest rates with increased borrowing. But the model pathways churn along and level off as debt increases because as in reality the Fed (the U.S. central bank) is assumed to set the interest rate with a constant “real” interest rate policy. Hence, the key effect of rising debt is to generate rising payments to those wealthy enough to own government bonds, notes, and bills. In principle—and in practice with the pro-growth Fed Chair Powell in charge at the Fed—interest rates need not rise significantly, stifling activity fueled by private-sector debt.

The anticipated crowding out effect is related to the high deficits, high interest rate policy combination experienced under 1980s president Ronald Reagan and monetary “hawk” Paul Volcker. Notably this situation brings a capital influx of money searching for high-return, low risk financial investments, driving up the value of the dollar. Effects of a true 1980s scenario with a Volcker in charge and deficits large enough would include a higher burden to foreign debtors of debt in dollars and an increase in trade deficits. But that will depend mostly on the Fed policy.

Effects not shown in my simplified model include a portfolio-safety effect of large amounts of debt that can be paid back with no need to default ever.

Numerous issues and concerns also come up in the details of the proposal involving corporate taxes, changes to personal income tax deductions, treatment of overseas corporate cash, and more. I will leave those for another day. That was a lot to get off my chest.

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