Abba Lerner's Functional Finance

SAN JOSÉ STATE UNIVERSITY
ECONOMICS DEPARTMENT
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:

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 pressure.
So long as the public is willing to hold government debt there is no economic problem with the national debt.

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.

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