Sorry, Larry Kudlow: Raising Taxes In A Recession Can Make Sense

The recipe is simple. When the economy is struggling, you cut taxes; when it’s booming, you raise them. It’s basic Keynesian economics, right? Everyone knows the formula, even Larry Kudlow:

If John Maynard Keynes were here, after this pandemic contraction, and you asked him, “Mr. Keynes, should we be raising taxes?” I guarantee you, from the general theory, which I have read, he would say no. He would say no.

I’m glad to know that Kudlow has done the assigned reading — The General Theory of Employment, Interest and Money is good background for any director of the White House National Economic Council. But Kudlow is exaggerating the Keynesian proscription against tax hikes during a recession.

To be sure, Keynes was generally inclined to cut taxes, rather than raise them, in the face of economic contractions; along with increased spending, that sort of expansionary fiscal policy was a good way to boost aggregate demand. But Keynes also argued — in various works, including The General Theory — that specific tax increases might also be used to speed recovery rather than slow it.

Keynes’s insight, moreover, hasn’t been lost on modern-day economists, some of whom are now making the case for targeted tax hikes, even as the nation struggles to recover from the COVID-19 contraction.

Keynes on Tax Cuts

Before we start mining Keynes’s work for useful policy guidance, it’s important to keep in mind how frustrating that task can be. Keynes wrote frequently for a popular audience, and some of that work included specific policy recommendations. But Keynes’s most famous scholarly writing — including The General Theory — is notably light on policy details.

Zach Carter, the author of a recent, highly readable Keynes biography, made this point in recent comments. “It is a mistake to think of The General Theory as a set of policy prescriptions,” he warned. While it includes more than a few, it’s best read as “a book about the relationship between the government and society.” What does that mean for people reading it today? Carter has words of caution: “If you want to invoke Keynes to justify a particular policy idea, go for it. But please take the time to understand the nature of the ghost you are conjuring.”

Keynes’s insight hasn’t been lost on modern-day economists, some of whom are now making the case for targeted tax hikes, even as the nation struggles to recover from the COVID-19 contraction.

Point taken. But let’s conjure a few ghosts anyway — how else can we evaluate Kudlow’s claim that Keynes would disapprove of tax hikes in the midst of a recession?

In the early 1930s, as Keynes was still working to complete The General Theory (which wouldn’t appear in print until 1936), American political leaders were doing their best to mount a fiscal response to the Great Depression. Tax revenue had fallen precipitously after the 1929 crash, and policymakers — captive to notions of “sound” public finance — had been searching high and low for ways to slow the river of red ink. The Revenue Act of 1932 was their greatest “achievement” in this regard, representing the largest peacetime tax increase in U.S. history to that point.

Not everyone was a public finance traditionalist, however, even in 1932. A small but growing contingent of economists had been counseling a more flexible approach to national budgeting, urging lawmakers to avoid both large tax increases and dramatic spending cuts. Such thinking was unconventional but not especially unusual by the time Franklin D. Roosevelt took office in 1933. And increasingly, champions of this approach emphasized the role that expansionary tax policy might play in fostering recovery.

For example, members of the Commission of Inquiry Into National Policy in International Economic Relations, a group convened by the Social Science Research Council in late 1933, gently chastised the new Roosevelt administration for ignoring the utility of tax cuts as a recovery tool. “The administration has given perhaps too little attention to temporary tax reduction as a means toward the desired deficit,” the panel wrote in its report. “In general, a deficit achieved by tax reduction is as reflationary as one obtained by extraordinary outlays.”

That same year, Keynes himself made a similar point in his pamphlet “The Means to Prosperity,” arguing that tax cuts would have the same expansionary effect as loan-financed government spending. “For the increased spending power of the taxpayer will have precisely the same favourable repercussions as increased spending power due to loan-expenditure, and in some ways this method of increasing expenditure is healthier and better spread throughout the community,” he wrote.

Using taxes to manage aggregate demand — cutting them during slumps and raising them during booms — was straightforward in theory but complex in practice. In the American context, for instance, almost half of all federal tax revenue came from excise taxes, which were awkward to manipulate quickly, especially since they were numerous and the focus of intense lobbying by affected industries.

The income tax, by contrast, was better suited to the task of compensatory taxation, at least in administrative terms. But it came saddled with political problems. In the early 1930s, it was paid almost exclusively by the rich, which meant that expansionary tax cuts would “serve largely to pour public funds into private hoards” — an unappealing prospect for many economists and more than a few politicians.

But economists — or at least some of them — had a possible solution for this problem: If expansionary tax reductions were politically problematic, what about expansionary tax increases?

Tax Hikes for Recovery

Everything turned on the question of saving, specifically on the propensity of rich people to save too much.

“We have to reckon with a tendency toward saving a progressively increasing proportion of our income as our income itself gets larger,” economist John M. Clark counseled in an influential Columbia University report on economic reconstruction published in 1934. Policymakers could “reckon” with this tendency by using progressive taxes (in conjunction with progressive spending programs) to redistribute some of that income from rich to poor. That redistribution would ameliorate the problem of “oversaving,” expanding aggregate demand and fostering economic growth.

Clark wasn’t the only economist thinking in these terms; Keynes was, too, and he gave the question of propensity to save extended attention in The General Theory. While his discussion of specific fiscal policies was rather limited, Keynes endorsed several taxes as an instrument for redistributing money from those less inclined to those more inclined to spend it.

“If fiscal policy is used as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the propensity to consume is, of course, all the greater,” Keynes wrote. Or even more to the point: “Measures for the redistribution of incomes in a way likely to raise the propensity to consume may prove positively favourable to the growth of capital.”

Keynes was no leveler; he was simply counseling against great disparities of wealth, which he thought impeded economic growth by promoting oversaving and underconsumption. Moderate degrees of inequality, on the other hand, were generally innocuous or even desirable. As he observed in one of his more famous passages: “It is better that a man should tyrannise over his bank balance than over his fellow-citizens.” But if economic accumulation were to serve as a political relief valve — as a means to satisfy some of humanity’s baser desires — it should be limited to moderate levels. “It is not necessary for the stimulation of these activities and the satisfaction of these proclivities that the game should be played for such high stakes as at present,” he wrote.

In none of these passages does Keynes closely examine the specifics of expansionary tax increases. But he clearly endorses the general proposition that some tax hikes can be salubrious for an economy operating at less than full employment — specifically, increases that redistribute income from those with lower propensities to consume to those with higher propensities.

Modern-Day Applications

Kudlow may have missed this message in The General Theory, but other contemporary economists were clearly paying attention. Consider, for instance, the recent op-ed by Kimberly A. Clausing in the Los Angeles Times. Clausing begins with a nod to the “seemingly plausible argument” that higher taxes might hinder recovery from the COVID-19 contraction. But she quickly pivots to the assertion that “some tax increases make sense, even during a recession.”

Clausing builds her case on an argument that Keynes would find familiar: Rich people spend less (and save more) than poor people.

Which tax increases? Clausing would reverse key elements of the Tax Cuts and Jobs Act, which she describes as “wrongheaded from the day it became law in late 2017.” More specifically, she would repeal provisions that granted “large tax cuts for the rich,” most of which did little to spur economic growth and much to make the tax system less fair. Her op-ed is light on details, as op-eds typically are. But elsewhere, Clausing has called for increasing corporate tax rates, repealing the section 199A passthrough deduction, and revamping the international corporate tax regime. She has also endorsed higher estate tax rates, tougher enforcement of existing tax laws, and efforts to protect the tax base from piecemeal (or wholesale) erosion.

All these moves would have “little effect on the incentives that drive economic growth” but would serve to raise revenue, increase fairness, and bolster taxpayer morale, Clausing contends.

Broadly speaking, Clausing builds her case on an argument that Keynes would find familiar: Rich people spend less (and save more) than poor people. Indeed, the marginal propensity to consume is 10 times greater for poor households than it is for rich ones, she writes.

Imagine a tax reform that rolled back tax cuts for the rich and simultaneously used the resulting revenue gain to expand a refundable child tax credit, Clausing says. “Those receiving the extra child tax credits will spend more of the additional dollars than if the money stayed in the hands of the rich, causing aggregate spending to increase.” She contends that such a tax reform would be good for the economy, just like many other tax increases on her list.

Clausing concludes with a challenge that Kudlow might do well to ponder. “The notion that taxes can never be raised during a recession is simple fearmongering,” she asserts. “Raising taxes on the wealthy and large corporations can be smart economics, even when the economy is weak.”

Lord Keynes might agree.