SAN JOSÉ STATE UNIVERSITY
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.
- The government should be concerned with balancing supply and demand at
full employment rather that balancing the budget. If aggregate demand at
full employment production falls short of the output at that level then the
government should take action to increase demand, by such maeasures as
cutting taxes, increasing government purchases or giving increased transfer
payments. Increasing government purchases could include undertaking
worthwhile public works projects such as building highways or improving
the public infrastructure. If aggregate demand exceeds aggregate supply
at full employment output the government should increase taxes or cutback
government purchases or transfer payments. The increase in tax in this
case is not to raise revenue but to decrease consumer demand by taking
away buying power from consumers.
- If the government needs funds to increase government purchases or
transfer payments it can raise it by borrowing through the sale of
government bonds or through the creation of money. The choice of how
much of the increased expenditure should be financed by borrowing versus
money creation is solely a question of balancing the supply of financial
assets with the public's demand for assets of various types.
So long as aggregate demand does not exceed aggregate supply there will be no inflationary
- So long as the public is willing to hold government debt there is no
economic problem with the national debt.
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
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