Economic stimulus: tax cuts vs. spending

Mainstream macroeconomic theory holds that there are two chief ways of providing economic stimulus, tax cuts and government spending. The stimulus bill passed last year opted almost entirely for the latter, as the much-hyped tax cut component was actually a collection of tax credits which are best viewed as simply another form of government spending. Over a year after the stimulus was passed we find significantly higher unemployment, increased debt and deficit levels, and indications that billions have been wasted on everything from socially conscious puppet shows to fish food.

So what would have happened if stimulus efforts had been devoted to tax rate reductions instead of government spending? While a definitive answer is impossible, Greg Mankiw provides some evidence they would have been far more effective than the approach which was adopted:

A great deal of recent economic evidence calls [the conclusion that government spending provides greater stimulus than tax cuts] into question. In an ironic twist, one key piece comes from Christina Romer, who is now chair of Obama's Council of Economic Advisers. About six months before she took the job, Romer teamed up with her husband and fellow Berkeley economist David Romer to write a paper ("The Macroeconomic Effects of Tax Changes") that sought to measure the influence of tax policy on GDP. Crucial to the Romers' method was their effort to identify changes in tax policy made during times of relative economic stability, and driven by a desire to influence economic behavior or activity (to encourage growth, say, or reduce a deficit), rather than those changes made in response to a recession or crisis. By studying such "exogenous" tax-policy changes, the Romers could be more confident that they were in fact measuring the effects of taxes and not those of extraneous conditions.

The Romers' conclusion, which is at odds with most traditional Keynesian analysis, was that the tax multiplier was 3 — in other words, that every dollar spent on tax cuts would boost GDP by $3. This would mean that the tax multiplier is roughly three times larger than Obama's advisors assumed it was during their policy simulations.

Of course, it could be that all multipliers are larger than previously assumed. Perhaps fiscal policy has such a great influence over our economy that, if the tax multiplier is 3, the government-spending multiplier is 4 or 5. We don't know from the Romers' study; they did not analyze government-spending multipliers, only tax multipliers. But several studies on government-spending multipliers have been conducted using techniques similar to those used by the Romers. And none has found government-spending multipliers to be so large as to justify assumptions about the inherent superiority of government spending over tax cuts.

Some excellent work on this topic has come from Valerie Ramey of the University of California, San Diego. Ramey finds a government-spending multiplier of about 1.4 — a figure close to what the Obama administration assumed, but much smaller than the tax multiplier identified by the Romers. Similarly, in recent research, Andrew Mountford (of the University of London) and Harald Uhlig (of the University of Chicago) have used sophisticated statistical techniques that try to capture the complicated relationships among economic variables over time; they conclude that a "deficit-financed tax cut is the best fiscal policy to stimulate the economy." In particular, they report that tax cuts are about four times as potent as increases in government spending.

Perhaps the most compelling research on this subject is a very recent study by my colleagues Alberto Alesina and Silvia Ardagna at Harvard. They used data from the Organization for Economic Cooperation and Development to identify every major fiscal stimulus adopted by the 30 OECD countries between 1970 and 2007. Alesina and Ardagna then separated those plans that were in fact followed by robust economic growth from those that were not, and compared their characteristics. They found that the stimulus packages that appeared to be successful had cut business and income taxes, while those that evidently did not succeed had increased government spending and transfer payments.

This is all thoroughly unsurprising, as tax cuts provide money to citizens to spend while government spending places funds in the hands of politicians. It is perfectly logical that those who earned the money in the first place will make better use of it than those whose main goal is pleasing various constituencies to assure their re-election. It would be nonsensical to expect anything else.

I further can't help but contrast Mankiw's approach rooted in academic study with the defense of the stimulus package being peddled by economist Alan Blinder, who wrote in the Wall Street Journal last week:

Try to imagine any government spending a massive sum like $862 billion without creating or saving millions of jobs. More specifically, suppose peak-year spending from the stimulus bill was about $300 billion—which is roughly correct—and that our hapless government just sprinkled its purchases around at random. On average, each job in our economy accounts for about $100,000 worth of GDP. (We are a highly productive bunch!) So $300 billion worth of additional GDP should be the product of about three million more jobs. Do we really believe the stimulus produced only a small fraction of that—or none at all?

Before the stimulus was passed, advocates assured us that it would succeed because the huge sums of money spent would result in significant job creation. Now, almost a year and a half later, the apparent argument is that because lots of money was spent, many jobs must have been created. How does one counter such logic?

Update: The academic literature continues to pour in:

As targeted assistance for stimulating local economies, [American Recovery and Reinvestment Act, aka "stimulus"] funding is uncorrelated with state unemployment rates. ARRA funding appears to be decided by congressional politics, given the desire to pass a major spending and tax relief package as quickly as possible.

Sounds about right.