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Spending Cuts Will Retard Recovery More Than Tax Hikes

David Callahan

Here's something I don't get. Republicans, and even some Democrats, say that now is not a good time to raise taxes because of the stumbling economy -- yet it's a fine time to cut spending. As Senator Ben Nelson, a Democrat from Nebraska, said in response to Obama's tax proposal, “There’s too much discussion about raising taxes right now, not enough focus on cutting spending.”

It makes perfect sense to worry that raising taxes could hurt the recovery. Which is why we have written here in favor of Obama's call last week to extend the payroll tax holiday for another year.

But what doesn't make sense is to fret about the damaging effects of tax hikes while championing deep spending cuts. Both tax hikes and spending cuts take money out of people's pockets and can hurt the economy. In an ideal world, we'd delay either measure for as long as possible. But if you have to pick one of these poisons -- if you believe that some deficit reduction is needed immediately and you want to do this with the least threat to economic recovery -- than tax hikes, especially on the rich and on business, are the way to go.

I'll get to the numbers in a minute, but let's start with logic first. Raising taxes on wealthy people and corporations is unlikely to significantly lower how much money they spend because they are sitting on big piles of cash and won't need to tighten their belts. The top 1 percent of Americans own over a third of all household wealth in the United States -- which the Federal  Reserve recently pegged at $58.5 trillion. So we're talking about $20 trillion in the hands of a few hundred thousand households. Likewise, U.S. corporations are said to be sitting on $2 trillion in cash after the last few years of record profits. "Corporations have a higher share of cash on their balance sheets than at any time in nearly half a century," reported the Wall Street Journal last week.

If I'm making a half million dollars a year, and using flush times to build my savings and home equity, a tax hike won't lead me to dramatically reduce my consumption. Rather, I'd spend only somewhat less and also sock less away for the future. If I'm a corporation with hefty profits and cash reserves, losing a tax break -- say for my corporate jet use -- won't be likely to change my plans for spending or hiring. I'll make those decisions based primarily on consumer demand.

This logic explains why tax cuts for the rich and corporations are such a poor form of stimulus. According to a recent analysis of "fiscal multipliers" by economist Mark Zandi and Moody's Analytics, cutting the corporate tax rate produces just $.32 of economic activity for each dollar lost by the U.S. Treasury. Dividends and capital gains tax cuts produce just $.39 and making permanent the Bush tax cuts would produce just $.35.

That's hardly a lot of bang for the lost buck -- especially if you're watching every buck.

But spending does provide a lot of bang for the buck, and cutting that spending therefore is far more damaging than raising taxes on the wealthy. According to the Zandi analysis, increased food stamp spending produces $1.71 in economic activity for each dollar in outlays, unemployment produces $1.55, and infrastructure produces $1.44. There's an obvious explanation for these fat dividends: You give money to someone who is hungry or unemployed and they'll spend it immediately, not save it so they can one day send their toddler to Yale.

I probably don't need to spell this out further, but I can't help but repeat my main point: The spending cuts that Republicans and some Democrats want to see happen now, will have a much more damaging effect on the economy than the tax hikes they say we can't risk for economic reasons.

To get out of the hole we're in, the folks making economic policy need to get their story straight and make policy that conforms both with common sense and the facts.