In the newly-revised edition of his book The Return of Depression Economics, Paul Krugman writes that
The quintessential economic sentence is supposed to be “There is no free lunch”; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch … because there are unemployed resources that could be put to work.
Is there a Keynesian free lunch with respect to government revenues? The idea is that heavy government expenditures and/or large temporary tax cuts will increase demand and thereby invigorate the economy. This will produce larger tax revenues several years down the road than would otherwise have been the case, helping to offset the deficits incurred now.
This seems plausible. But it sounds suspiciously similar to the claim made by “supply-side economics” advocates: a reduction in tax rates will increase investment and hence growth and thus government revenues, offsetting the short-run loss in revenues due to the tax cut. If you don’t buy the supply-side free lunch claim, and relatively few serious analysts do these days, why should you believe its Keynesian counterpart?
One distinction lies in the hypothesized magnitude of the effect. The Keynesian version I’ve seen suggests that a large government deficit will be partially recouped by the resultant spur to economic growth, whereas the supply-side claim tended to be that the revenue loss from a tax cut would be fully or more-than-fully offset.
Another difference lies in attention to context. If the current tax rate is high enough that it really does impede investment, the supply-side free lunch exists: reducing the tax rate will yield little or no loss in government revenues. Put another way, the so-called “Laffer curve” is a reasonable depiction of reality. But its proper application requires asking where the current tax rate lies on the curve — whether, in other words, the current tax rate actually is impeding investment. Few supply-siders bothered to take this question seriously, and the notion became a blanket rationale for continued tax cuts. The experience of the past several decades has not been kind to the claim (see here and here).
As best I can tell, few contemporary believers in a Keynesian free lunch view it as context-independent. The hypothesis is that in conditions of a significant shortfall in demand and limited potential for further help from monetary policy, such as our present situation, an increase in the current government deficit is likely to stimulate enough growth to partly offset the cost.