Stimulus: tax cuts vs. spending

I found this part of a Greg Mankiw speech from last December rather interesting. Mankiw noted a 2009 paper by Christina Romer, the current chairman of the Council of Economic Advisors for President Obama, which found a multiplier effect of 3 for tax cuts (every dollar spent on tax cuts will raise GDP by $3). He then goes on to state:

The best work on this topic, I think, is from Valerie Ramey at the University of California at San Diego (Ramey, 2009). Ramey finds government spending multipliers of about 1.4, which is not very different from what the Obama Administration assumed, but much smaller than the Romers found for taxes. Similarly, Andrew Mountford and Harold Uhlig, using vector autoregression techniques, have also found that taxes have a more potent effect than government spending (Mountford and Uhlig, 2009).

The piece of evidence I want to draw your attention to in particular, though, is some very recent work by my colleagues Alberto Alesina and Silvia Ardagna at Harvard. They used OECD data to identify every major fiscal stimulus in those countries (Alesina and Ardagna, 2009). They then separated out the successful polices—those that in fact were followed by robust economic growth—from the unsuccessful ones and compared their characteristics. They found that the successful stimulus packages cut business and income taxes and the unsuccessful stimulus packages increased government spending and transfer payments.

The data in the Alesina-Ardagna study are mostly European, with only a small portion from the United States. But they lead to conclusions that are very similar to those from Mountford and Uhlig’s work using U.S. data in vector autoregressions. These conclusions are also consistent with the work from Ramey and the Romers that looks at the historical record to identify multipliers. There appears to be a growing body of evidence suggesting that taxes may be a better tool for fiscal stimulus than conventional models have indicated.

On the flip side, our experience with the stimulus package thus far, which emphasized government spending, suggests significant shortcomings with that approach.