Thayer Watkins

Abba Lerner's Functional Finance
Abba Lerner articulated a fiscal strategy for the Federal Government which traces Keynesian macroeconomic analysis to its logical conclusion. It is presented here as one extreme of the debate concerning the surpluses and deficits of a national government.

Functional finance takes the following positions:

Lerner also presents some arguments concerning the effects of taxes which are not part of Functional Finance but are relevant. The tax rate on the profits of investment should not affect the level of investment if the costs of investment are tax deductible. The theory of investment says an investment project will be undertaken if the net present value of the after-tax cash flow is positive. The effect of the profit tax is to reduce the net present value figure by the amount of the tax but would not change a positive value to a negative value or vice versa. Thus Lerner's position is that investment spending is insensitive to the profit tax rate.

Lerner believes that there is a multiplier effect from changes in fiscal policy that does not have an offsetting change intended to balance the budget. That is to say, if there is an increase in government purchases without a corresponding increase in taxes the increase in GDP will be a multiple of the increase in government purchases. If taxes are increased at the same time government purchases are increased the stimulus to demand caused by the increase in government purchases will be largely offset by the decrease in consumer purchases due to the increased taxes. Measures to stimulate demand are thus accompanied by an increase in the government deficit (or decrease in the surplus).

Lerner notes that the payment of interest on the national debt is taxable. Thus when the government pays out $100 billion in interest a significant share of that comes back in terms of income taxes, say $30 billion. Thus it is reasonable to use the net aftertax interest payment in any calculation of the budget balance rather than the gross payment of interest.

Abba Lerner's Functional Finance generally evokes fear from fiscal conservatives and never was accepted even among Keynesian economists. Remarkably the one time that it came closest to being implemented was with the Reagan Administration. While the rhetoric of supplyside economics was promoted the fiscal policy in practice had a remarkable similarity to Functional Finance.