Three Views of the "Fiscal Cliff"

May 23, 2012

Barring action by the president and Congress, a combination of tax increases and spending cuts are set to be imposed in 2013.  There are multiple perspectives on this occurrence that are informed by widely varying economic theories.  In drawing our own conclusions, it is crucial to understand each one individually, focusing on the three primary schools of thought, says Edward P. Lazear, a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.

First, there is the Keynesian approach to this policy.

  • Keynesians see tax increases and spending decreases as a lose-lose for the economy.
  • With the loss of some government spending in the economy at large, there will be a noticeable contractionary effect.
  • Furthermore, tax increases will reduce aggregate consumption, adding to the contraction.
  • Consequently, most Keynesians see the coming austerity as a "fiscal cliff."

Second, there is the oft-ignored school of thought of budget balancers, who focus almost exclusively on the state of the budget, giving special attention to deficits and debt.

  • Budget balancers see the coming package as a win-win for the long-term outlook.
  • They argue that a government that takes on unsustainable debts in the short-term will mortgage its long-term prospects, and therefore elimination of budget deficits should be prioritized.
  • Most budget balancers advocate the Simpson-Bowles plan.

Third and finally, supply-siders see the coming fiscal changes as a mixed bag.

  • Fundamentally, supply-side advocates focus on the harmful effects of tax increases.
  • Raising tax rates, they argue, hurts the economy directly because tax hikes reduce incentives to invest and because they punish hard work, thereby slowing growth.
  • While they see the package as a win-loss because they appreciate the smaller government associated with lower spending, they tend to focus on the tax increases.

While it is difficult to say which perspective is the most accurate, it is difficult to deny the fundamental pitfalls of Keynesians' approach.  Keynesians often fail to account for the fact that stimulus today will have to be withdrawn at some point (government deficits are unsustainable in the long run), and that a kick-the-can down the road approach is an ill-advised path.

Source: Edward P. Lazear, "Edward Lazear: Three Views of the 'Fiscal Cliff,'" Wall Street Journal, May 20, 2012.

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