The 2012 election campaign has been under way for a while now, and I thought it would be worthwhile to write about it. This election very quickly became a battle over the economy, with the republicans trying to say that Obama’s doing a horrible job and Obama trying to prove them wrong. Mostly, the republicans have been claiming that the best way to create jobs is through tax cuts and deregulation, essentially making it so that people spend less on taxes and can spend more on whatever they would buy with that money. This is called supply side economics, and it relies on the idea that if businesses have more money, they will spend more on jobs, and can afford to make cheaper goods. Obama (and most democrats) argue that taxes are necessary to pay for services, and so the best way to stimulate growth is to spend money. These “spending packages” generally involve some kind of effort to create jobs or give money to middle class and poor citizens.
In the end, both of these ideas have the same purpose: to generate growth in the economy, stimulate spending, and create jobs. The problem is that neither of them do all three of those. Here’s why:
Supply Side Economics (The Republican Idea)
Why it should work:
Supply side economics is theoretically a great idea. If you lower the operating costs for a business, they should theoretically be able to lower their marginal costs, and can then afford to produce more of their product at a cheaper price, which would necessitate hiring more workers. This would produce economic growth, stimulate spending, and create jobs.
The problem with supply side economics is threefold. First is that this is done by lowering taxes, which means that the government would have to cut programs, some of which may provide economic and social benefits to some people. Second is that most businesses and people are risk averse. Lets look at an example. In this example, you have two options: be given $200, or be given stock that is worth $200. There is a 2/3 chance that that investment will grow in value to $350, and a 1/3 chance that it will fall apart, and you’ll have nothing. The last option has a higher expected value, and has the chance to give you an extra $150. However, many people will choose the $200 option regardless because there is a chance that you will lose all your money with the second option. This is important because the people who will benefit the most from a tax cut are businesses and the very wealthy. For them, the majority of this money will not go towards spending, as they usually have much more money than they can spend. Most of it will be invested. However, as we just proved, people are risk averse. They will not invest all their money for fear of the possibility of losing it, and they won’t spend most of what they don’t invest. Much of this money will just sit in a savings account or be invested in a low risk asset such as a treasury bond so that the person will always have a guaranteed stockpile of cash if their other investments fail.
The second problem is one of market size. As we mentioned before, the largest benefactors of tax cuts are the wealthy and businesses. Theoretically, a tax cut should lead to growth, but the question is if the tax cut will lead to equal growth (will a 5% tax cut lead to 5% more spending by businesses?). The answer: not necessarily. There is only so much space in any market, so a business can only grow by so much. If they get a 5% tax cut, but can only grow enough to warrant 3% more spending, then they’ll only spend an extra 3%, and keep what’s left over. Also, during a recession, which is what everyone’s worried about right now, the problem isn’t always one of not being able to meet the market’s demands. It’s just as much about the market shrinking. If my market shrinks, my sales dry up, and I lay off workers to cut costs. I won’t start hiring again until it looks like demand is going to pick up.
Stimulus (the Democratic Idea)
Why it should work
Stimulus works generally through two avenues: tax rebates for the middle and lower classes, or government projects that create jobs in manufacturing, construction, and other sectors. These should theoretically work by lowering unemployment and giving the middle and lower classes some money to spend. These are people who don’t necessarily spend as much as they’d like to because they don’t have the ability to. Given extra money, they should be more prone to buying something that they wouldn’t otherwise. That money then is cycled through the economy, and the process creates growth.
The problem with this is also threefold. First is that it would involve higher taxation for some people, which means that the positive effects of this are somewhat negated by the fact that their money is going to taxes and not something that is necessarily economically beneficial. This also increases government spending at a time when we need to close the budget deficit. Second, it has the same pitfall as supply side economics in that people are risk averse. Although the extreme poor may not be able to afford to do this, middle class taxpayers will inevitably put some of the money away in a savings account so that they have it in case they need the money later down the road. Third is that the jobs created by government programs, such as construction jobs on infrastructure projects, are often temporary, and don’t provide permanent economic growth. The hope, then, is that the temporary job growth will lead to increased spending in the short term, which may provide more long term benefits.
All that being said, I have a question for my readers: what economic “class” are you in, how old are you, and what party do you affiliate with?