FOO Law and Economics

Friday, February 6, 2009

Taxing cuts for the Philippine economy

The debate on the proper stimulus in today’s global crisis rages between two disparate schools of thought – Keynesians (considered as the orthodox economists) and the Austrian school (which emphasizes libertarian values).

The Keynesian view is that unemployment stems from inadequacy of aggregate demand, amidst "sticky" wages and prices. Accordingly, the remedy is for the government to make up for the "lost" aggregate demand. The Austrian school, on the other hand, believes that it is better to do nothing because the problem is maladjustment of the economy that led to the previous bubble. The remedy is to allow the economy to adjust on its own, unless the government can do better through “social engineering.” To the Austrian school the best remedy is to cut taxes, avoid printing money, and not to change the rules too often. Unfortunately, politicians prefer the Keynesian remedy because they can appear as generous “saviors” in a time of crisis.

On the merits, neither school’s proposal offers a complete fix. If the Austrian view is correct, then the Keynesian stimulus will work only when the unemployed resources are re-absorbed in a healthy economy (in the US, it would be an economy without the excesses of the housing market, the "toxic" assets in the financial system, etc.). The Austrian prescription of "doing nothing" is also incomplete. After all, there are pockets of the economy without "mal-investments" but suffer along with the rest. And so long as there are wage and price rigidities, the Keynesian analysis of unemployment cannot be denied.

The Austrian school can at least explain why and how the crisis might take a while. That is no mean achievement. Experts who have studied the history of past crises note the need for a painful phase of financial restructuring in the U.S. economy, and here there is agreement between the two schools of thought.

But there is another common ground between Keynesians and the Austrian school. Both support tax cuts. The official Philippine view provides for a P330 billion stimulus package. It seems that such a stimulus can be had by a cut in the VAT rate from 12% to 8% and by a similar cut in income tax rates. Such tax cuts would be the better stimulus where their place in the stimulus package is not controversial among economists. In the Keynesian textbook, tax cuts have large-enough multiplier effects if those receiving the tax cuts save little. To the Austrian school, tax cuts put pressure on politicians to run a more efficient government.

It may be argued that tax cuts would add to the fiscal deficit. But the same is true if the stimulus were through government expenditures. The problem with fiscal deficits is that they portend an inability of the government to collect taxes, or its willingness to spend unwisely, which could ruin a country's debt rating. But if public finances are sound, public investments would be self-financing. In other words, what matters for fiscal policy is not the size of the deficit but its “quality”– whether the government spends well and taxes fairly. There should then be no fear of undue debt burdens in the future since a responsible government would be able to recover the "lost" revenues from tax cuts as the economy emerges from the crisis. If the Keynesian school is right, the tax cuts will have to be undone later, and therefore they should be reversible, as emphasized by IMF staff. For the Austrian school, the tax cuts could well be made permanent if they promote economic growth and help restore balance in the public finances.

Hippocrates once said, "Declare the past, diagnose the present, foretell the future; practice these acts. As to diseases, make a habit of two things — to help, or at least to do no harm." Economists should hew to the same idea, particularly where they can agree on a solution that does no harm. The citizenry expects no less from the country’s economic managers.

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