Is Government Spending Better Than Reducing Taxes?

The traditional Keynesian view is that government spending is better than reducing taxes for stimulating the economy. I disagree.

The answer to an Aplia assignment question which accompanies a popular Mankiw economics textbook mentions the following:

Traditional Keynesian analysis indicates that increases in government purchases are a more potent tool than decreases in taxes. When the government gives a dollar in tax cuts to a household, part of that dollar may be saved rather than spent; the part of the dollar that is saved does not contribute to the aggregate demand for goods and services. By contrast, when the government spends a dollar buying a good or service, that dollar immediately and fully adds to aggregate demand.

There are at least four problems with this explanation:

  1. Aggregate demand increasing is not market demand increasing. The entire aggregate demand function is garbage and everyone knows it. Government spending money does not improve general market demand. It improves demand for certain goods, but generally creates a burden because the benefits it creates are less than the harm it inflicts once opportunity costs are accounted for.
  2. Relatedly, malconsumption is a thing. When government spends, it spends wrong. If the government engaged in a tax cut then the market would allocate the consumption, or saving. Consumption when you should be saving is just like consumption of the poorly selected good; it is also malconsumption. Government also famously engages in cronyism and waste far beyond the character of the competitive market.
  3. Public action creates precedent and facilitates continued similar action. In particular, spending becomes entrenched and results in a growth of the size of the government. Tax breaks seem to be resistant to entrenchment, but if they did become entrenched that would be a good thing anyway. In short, government spending grows the size of government while tax breaks don’t as much.
  4. While direct government spending will stimulate demand to a larger degree in the short run, this stimulation is much more likely to result in a slowing and lengthening of the recession or depression than it is to result in a bounce out of the recession or depression. Markets must fundamentally correct themselves. Confusing distortions and artificial positive price signals generated by government spending merely make the natural correction much more slow and painful.

In conclusion, it is true that a dollar spent by government immediately and fully adds to aggregate demand. It is not true that this makes it a good thing, nor a “more potent tool.” The very fact that it represents a stronger boost to aggregate demand makes it more dangerous by malconsumption risk through a more concentrated, less market-oriented decision mechanism when compared to a tax cut.

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