The U.S. government is spending trillions of dollars to support the economy as it works to contain the fallout from the coronavirus pandemic. There hasn’t been much discussion about how all this spending will be paid for, but those talks are coming and they will not be pleasant.
To be clear, this level of spending cannot be financed by tax revenue alone, but lawmakers will surely try, even if just for the sake of appearances.
Even before the Covid-19 crisis, the federal budget deficit was about $1 trillion, or 5% of gross domestic product. That’s not an extreme level historically; the shortfall reached 10% of GDP during the financial crisis in 2008-2009. What’s different now is that the spending will be much bigger, with $2.2 trillion approved already, including sending checks to individual taxpayers along with bailouts for companies that probably don’t deserve them. I don’t think anyone seriously believes the first $2.2 trillion of stimulus is going to be the last, especially if we are unsuccessful at stopping the spread of infections.
Indeed, right after the Coronavirus Aid, Relief and Economic Security, or CARES, Act was signed, President Donald Trump began planning for even more spending via a $2 trillion infrastructure bill. For perspective, the budget that the White House submitted for 2020 totaled $4.8 trillion, so these two measures would nearly double that in short order. It won’t be long before someone gets the idea that if the U.S. can spend $2 trillion on corporate bailouts, then it can bail out student-loan borrowers as well, which would probably cost an additional $1.6 trillion.
Even if the U.S. raised tax rates on every American to 100%, the revenue generated would barely cover the additional spending. And if the government tried to sell $6 trillion of Treasury securities in a condensed period, the bond market would become unglued, sending borrowing costs skyrocketing higher. The only way that wouldn’t happen is if the Federal Reserve monetizes that debt by buying bonds directly from the Treasury Department. We aren’t at that point yet, but it’s probably not far away, either. The U.S. will be ramping up its borrowing and if the bond market reacts poorly, the Fed will be asked to cap yields.
This is more or less what people refer to as Modern Monetary Theory, or MMT. It’s also basically where we are now, except the Fed isn’t buying bonds directly from the Treasury but rather on the open market from investors, who buy them from the Treasury. The traditional way of thinking about all this is that government spending is constrained by how much it can collect in taxes and how much borrowing the bond market can withstand. Under MMT, there is zero constraint on what a government can spend because it can all be financed by a central bank’s purchases of the bonds issued to finance the spending.
I’ve been critical of MMT because it suggests there is no such thing as economic tradeoffs. You can have your dollars or you could have your aircraft carrier, but you can’t have both. With MMT, you can have both the dollars and the aircraft carrier. What MMT doesn’t seem to consider is the resulting decline in the purchasing power of those dollars.
The other tradeoff that doesn’t exist under MMT involves revenue collection. Since a government isn’t dependent on tax revenue to finance spending, tax rates are basically arbitrary. They could either be very low or they could be very high; it doesn’t matter, since they are incidental to how the government is financed. So what should tax rates be in an MMT world? The answer is driven by ideology.
The Treasury typically seeks to set tax rates to collect an optimal amount of revenue. Set them too low, and the government doesn’t collect enough revenue. Set them too high, and people find ways to avoid taxes, and the government loses out on potential revenue. Studies show that the government’s tax revenue is about 20% of GDP over time, regardless of where rates are set.
I worry that in an MMT world, tax rates will be driven entirely by ideological concerns, rather than practical concerns such as revenue collection. One might think that if the government doesn’t need to collect revenue, it could eliminate income taxes. But that wasn’t the sentiment when MMT was being discussed heavily last year. Economists wanted MMT and high taxes for moral reasons; many simply find it offensive for wealthy people to keep most of what they earn.
Watch for discussions about taxation to be completely unmoored from economic reality. It’s already happening to some degree. Far left members of Congress who have called for confiscatory tax rates did not do so because they made economic sense; they did so out of a sense of fairness. That’s how high tax rates become possible in an MMT world, because they don’t actually have to work, and it doesn’t matter if they do.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World." He may have a stake in the areas he writes about.
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