Is Government Spending More Effective than Tax Cuts During a Recession?

Paul Krugman says:

Spending versus tax cuts, by Paul Krugman: Jeff Frankel says what I wanted to say about what we know so far about the impact of the stimulus:

Martin Feldstein and others predicted that the tax-cut component of the 2009 fiscal stimulus package would have substantially less expansionary bang-for-the-buck than the spending component of the package, because much of the tax cut would be saved, as had been the case with the 2008 tax cut. (“Bang for the buck” in this case could be defined as demand stimulus divided by budget cost.) We knew this from Milton Friedman’s permanent income hypothesis, or even from good old Keynesian multiplier theory.

And sure enough, that’s what’s happening.

It’s worth emphasizing this point, because there’s been a lot of nonsense written about the issue. Take this conspiracy theorizing from Clive Crook:

Politics more than economics guided the design of the first stimulus, after all. Democrats preferred public spending because they wanted to widen government’s role and repudiate the Republicans’ instinct to cut taxes regardless of the circumstances.

Um, no. Democrats preferred spending because they feared, based on quite standard economics, that tax cuts would be ineffective. And so they have proved.

There are two ways in which tax cuts can help. First, if the money is spent, it stimulates aggregate demand, output, and employment. This is what people generally have in mind. Second, tax cuts that are saved can shorten the length of recessions. When the income from tax cuts is saved rather than spent, that helps households refill damaged balance sheets. Consumption levels will not return to normal until balance sheets are repaired, so tax cuts can help to bring about the end of a recession sooner than otherwise because they allow balance sheets to be repaired faster.

However, it is not clear that tax cuts are better than government spending at shortening recessions. Recently, Menzie Chinn posted evidence from this paper that government spending on consumption (as opposed to infrastructure) has a larger recession shortening effect than tax cuts, though tax cuts can also be effective at this task if they are properly constructed:

This paper assessed the effects of fiscal policy responses during 118 episodes of systemic banking crises in advanced and emerging market economies. The results indicate that timely countercyclical fiscal responses (both due to discretionary measures and automatic stabilizers), accompanied by actions to deal with financial sector weaknesses, contribute to shortening the length of crisis episodes. During crisis caused by financial sector distress, fiscal expansions increase the likelihood of earlier exit from a shock episode. …

The composition of fiscal expansions matters for crisis length — a point that has not been studied in the literature. Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment. A 10 percentage point increase in the share of public consumption in the budget reduces the crisis length by three to four months. Reducing the share of income taxes is less effective than consumption taxes in shortening the length of a banking crisis. These results suggest that tailoring the composition of fiscal response packages is important for enhancing the effectiveness of countercyclical fiscal measures in both advanced and emerging market economies (Spilimbergo et al., 2008; IMF, 2009).

Notice that it is government consumption, not government investment, that has the biggest effect on shortening the duration of recessions. Also note that cuts in taxes – particularly cuts in consumption taxes – also have this recession shortening effect.

Thus, the tax cut component of a stimulus package can play a useful role in shortening recessions, though apparently government consumption does even better (however, fiscal policy devoted to government consumption is politically difficult because, as I have noted many times before, government spending that does not directly increase economic growth is viewed as wasteful, or at least not as desirable as growth enhancing policies, and therefore tax cuts may be all that is available to policymakers).

As a result, policy faces a tradeoff between stimulus to short-run aggregate demand that impacts output and employment relatively fast, or delayed stimulus that has a larger impact on economic growth. For example, as the paper notes, growth enhancing policies are distinct from the policies that have the most immediate impact:

The quality of the fiscal stimulus package matters most for post-crisis growth resumption, with fiscal responses relying largely on scaling up the share of public investment in the budget showing the largest positive effect on medium-term output growth. A one percent increase in the share of capital outlays in the budget raised post-crisis growth by about ⅓ of one percent per year. Income tax reductions are also associated with positive growth effects.

The results of the short-term and medium-term impacts of fiscal policy during financial crises highlight a potential trade-off between short-run aggregate demand support measures and medium-term productivity growth objectives in fiscal policy response to shocks. Implementation lags for government investment, which were documented also during the current crisis, may be, at least in part, responsible for these results. They also point to careful consideration of the composition of fiscal stimulus packages, as different short-term and medium-term fiscal multipliers can affect fiscal policy performance during the crisis and in its aftermath.

So what is the bottom line to all of this? It says that fiscal policy ought to include a portfolio of government investment, government consumption, and tax cuts (if government consumption is difficult politically). Tax cuts on consumption and government consumption have a relatively immediate impact both on aggregate demand and on the rate at which balance sheets are repaired, and income tax cuts along with spending on infrastructure are better at enhancing long-run growth.

Thus, my view is not that the tax cut component in the current stimulus package were a complete mistake, tax cuts can help to shorten recessions as described above, and this effect occurs both because tax cuts help to repair balance sheets when the tax cuts are saved, and because they stimulate consumption. But the effectiveness of the tax cuts in the short-run could have been improved by targeting consumption rather than income. So the tax cuts could have been constructed much better, and government consumption may have had an even larger effect. What I haven’t been able to determine, however, is which type of tax cut, income or consumption, has the bigger effect on balance sheet repair (saving) rather than aggregate demand (consumption), though I suspect that income tax cuts would have the larger balance sheet effect.

The mistake is that the government consumption component was much too small. The package should have been much larger, and proportionately more of the package should have gone to government consumption measures (which do not have to wait until projects are “shovel-ready” before they can be implemented) rather than income tax cuts and infrastructure. The package contained more than enough measures devoted to long-run economic growth, but far too few devoted to simulating aggregate demand immediately.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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