The following is an excerpt from a longer article published by Victor Canto, PhD, who serves as an economic consultant to TPCM. To inquire about the full article please visit LaJolla Economics website.
A major assumption behind the Biden administration economic policy is that government spending drives the economy’s aggregate demand. The policy implication yielded by this approach is a simple one: more spending leads to higher output and employment. In other words, in our opinion, the Biden administration is trying to spend its way into prosperity. We refer to this economic framework as “Bidenomics”.
But there is reason to believe that Bidenomics as we have described implicitly ignores several effects that we consider important and would lead to an overestimation of the positive impact on GDP. Stimulating the economy’s aggregate demand is only half of the story determining the equilibrium level of output. The other half is the aggregate supply. Under the pandemic shutdown, it did not matter how much stimulus is provided to the economy, if supply is not forthcoming, the increases in aggregate demand only lead to increases in prices – which we have seen.
Likewise, there are significant differences of opinion regarding the impact of marginal tax rates on economic behavior. The Biden administration, the Build Back Better plan (BBB) and related measures focus mostly on the impact of the programs on the economy’s aggregate demand. As noted above, it assumes that the policies would lead to an increase in aggregate demand and thus output and employment. The administration implicitly and quite often explicitly assumes that the substitution effects are not large enough to offset the aggregate demand effects. This opinion is not universally held and there are reasons to question the presumed magnitude of aggregate demand increases. If there is no aggregate demand effect, all we are left with are the substitution effects and they are not kind to the administration’s views.
Ignoring the substitution or disincentive effects leads to wrong forecasts. One example that illustrates what we have in mind is an issue widely discussed in the press concerning the American Rescue Plan Act (ARPA), which provided for a supplemental $300 per week unemployment check from the federal government. Several economists have calculated that a large portion of the population made more money after tax by not working and collecting the unemployment benefits than by working. According to our logic, these workers faced an implicit marginal tax rate of more than 100%. By choosing not to work, they behaved rationally and responded to the incentive structure.
But do we have any corroborating evidence to support our hypothesis? We believe so and would point to the impact of ARPA after it expired. Our incentive theory suggests that as the benefits expire the portion of the population that without the $300 check would make more by working than not working, would choose to return to the job market. This insight would forecast a surge in employment well above the consensus forecast based on assumptions that ignore the incentive effects. Hence the upside surprise in employment numbers reported in October were not a surprise as it was the first reporting month after the expiration of the weekly benefits and that is when supply siders would expect a surge. In contrast, forecasters who did not consider the incentive effects were surprised by the surge.
Further evidence of the impact of the disincentive effects is the well documented data that shows the migration from the high tax rate states towards the lower tax rate states. One can also compare the unemployment rate across states. In several states that imposed fewer Covid restrictions they witnessed stronger economic growth when compared to states that have more restrictive Covid policies. Nebraska’s unemployment rate ticked down to 1.9% well below the national jobless rate of 4.6%. Utah recorded a 2.2% unemployment rate. Idaho, South Dakota, and Oklahoma all had unemployment rates below 3%.
Correlation does not necessarily prove causality and individually the results do not appear to be very significant. But taken together they do add up and a clear picture emerges. Collectively these results show that changes in tax rates, regulations and means testing will alter the incentive structure faced by economic agents and that, in turn, will impact their work and location decision. Ignoring these substitution effects could be perilous to forecasters and policy makers. If this analysis is correct, it points to a simple fact. At best, the Biden administration is overestimating the potential economic benefits from Bidenomics. If implemented, BBB will likely fall short of its economic objectives. We just hope that the overestimation error is not large enough to leave the economy worst off.
Once one buys into the BBB explicit and implicit assumptions, the policy recommendations and conclusions flow logically. Hence there is no sense in debating the logical construction of the BBB approach. To question the BBB forecast, one must question the assumptions behind the analysis. We have two major disagreements with the BBB assumptions:
• We believe that the aggregate demand effects of the government expansion and their impact on the economy are overestimated.
• We also believe that the disincentive effects and their negative effects on the economy’s aggregate supply are underestimated by quite a bit, since they are non-existent in the BBB analysis.
If our assessment is correct, the BBB plan will not deliver the goods.
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