The evidence on tax cuts vs. spending is ... confusing
The Great Debate over whether we should cut taxes or increase government spending to stimulate the economy has sent many of us noneconomists digging into the evidence economists have gathered on the topic. Most of it is, as Nate Silver put it after reading Christina and David Romer's big paper (pdf) on the macroeconomic effects of postwar tax changes, "the sort of thing that will make your head spin." But the even more dramatic conclusion I have come to after reading through the Romer-Romer paper and the most-cited recent work on the macroeconomic impact of changes in government spending, by UC-San Diego's Valerie Ramey (pdf), is that they don't even begin to resolve the debate.
This issue, basically, is that in a complex economy measuring cause and effect is really hard. In response to this difficulty, both Ramey and the Romers (sadly, they haven't started a band together, at least not as far as I know) have devised ways to separate signals from noise. And in both cases, this has meant excluding the sort of tax cuts and spending increases being contemplated today.
The Romers did this by compiling an exhaustive narrative of tax changes over the past six decades, and separating them into two main categories: endogenous (that is, motivated by a desire to stimulate a faltering economy or pay for planned increases in spending) and exogenous ("any tax change not motivated by a desire to return output growth to normal"). The effects of endogenous tax changes are especially hard to disentangle from other economic factors, their reasoning went, so they focused on exogenous tax changes and found a pretty substantial—as much as 3-to-1—negative impact on GDP from tax hikes and positive impact from tax cuts. The one exception: Tax increases explicitly intended to reduce a budget deficit didn't have much of a negative effect. The Romers also found a 2.1-to-1 impact for tax changes intended to counter a slowdown, but expressed very little confidence in that number—for the reasons expressed above and also because there just haven't been many such tax cuts in recent decades.
So the Romers identified a bigger-than-generally-assumed economic impact from tax changes, but didn't have much to say about precisely the kind of tax change being contemplated now, and didn't have anything at all to say about the relative efficacy of tax changes vs. spending changes. (Brad DeLong, who has worked down the hall from them at UC Berkeley for years, has something to say on what he thinks their stance is.)
Which brings us to Ramey, who in trying to identify government "spending shocks" big enough to have a measurable impact on GDP ended up focusing on sudden increases in defense spending through the years. The impact on GDP was unimpressive: 1.4-to-1. But remember, that's just defense spending. Why only focus on defense spending? Because, Ramey writes, "most nondefense spending is state and local spending on potentially productive activities such as education." For the purpose of getting a cleaner measure of the impact of government spending, she has excluded much of the kind of spending being contemplated today. And as with the Romers, there was no attempt to compare the impact of government spending with tax cuts—and the two studies seem different enough that lining up the Romer's 3-to-1 next to Ramey's 1.4-to-1, as Greg Mankiw did in the New York Times on Sunday, is really comparing apples to, I dunno, raspberries.
The reality here is that there is simply no clear answer in the data—especially since we only have really good data for the post-World War II era and the U.S. has not experienced a recession quite like this one in the post-World War II era. Which forces us to fall back on theory, and not just economic theory. If you believe that government is capable of spending money intelligently—or at least more intelligently than the currently paralyzed private sector—then more spending is the ticket. If you don't, you're going to lean toward tax cuts or no action at all.
Update pneogy points in the comments to a new Paul Krugman post in which he makes the case for spending vs. tax cuts. It still suffers from the limitation that it's based on theory, not any kind of conclusive empirical evidence, but Krugman adds an interesting twist:
If $100 billion in spending raises GDP by $150 billion, and the marginal tax rate is 1/3, $50 billion of the spending comes back in additional revenue. So bang for the buck — increase in GDP per dollar of added debt — is 3, not 1.5. Since the main concern about stimulus is that it will add to government debt, it's this bang for the buck measure, rather than the multiplier, that's relevant. And 3 sounds a lot better than 1.5.
I should add that I lean toward the idea that some big part of the stimulus plan ought to be spending. But I'm basing that on theory and ideology and hunches, not hard evidence. And I also think it's hard for government to quickly come up with smart ways to spend $800 billion. That's the assessment of Obama's economic team, too, which is why they're including tax cuts in their stimulus plan.
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1
Paul Krugman seems to think that spending provides a far greater "bang for the buck" than tax cuts.
http://krugman.blogs.nytimes.com/ -
2
Did the Romers factor in tax policy changes that accompanied tax cut rates? Did they consider the distribution of the increased GDP?
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Because the first factor probably has a great deal more to do with GDP changes than just cutting tax rates (when taxes were cut from 90%, huge swaths of income were protected from taxation through tax shelters that were decidedly "unproductive" -- and its probably impossible to determine whether it was the lower rates, or the end of the shelters, that added to the GDP.
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But more importantly, IMHO, is how were the benefits of these tax cut "gains" distributed. We now know, from both Reagan and Bush II's tax cuts, that "Trickle down" doesn't work, and tax cuts for the rich simply result in wealth being increasing concentrated among those with pre-existing wealth.
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Nor, as you note, does past experience tell us what to do in the current situation, where deficits are already disasterously high, and the economic damage that can be wrought by even greater tax cuts could well lead to a situation similar to what occurred in Argentina.
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Ultimately, the problem is that the economy is broken, and needs to be fixed. Irresponsible tax cuts (along with massive war-related deficit spending that does little to help the US economy) played a huge role in "breaking" th e economy, and continuing to pursue irresponsibly policies in the name of political compromise is simply stupid. -
3
I tend to agree with Krugman, but I think reasonable minds would all come to the conclusion that it is a matter of degree. Tax cuts can be good when they free up capital for more productive uses, but they can also be bad when they hamper or permit structural elements needed in an economy to go unfunded...i.e. roads get so poor it takes folks an hour longer to get to work. The same is true of spending. A little on upgrading our internet to be faster means formerly stay at home moms might be able to telecommute and stay at home and take care of the kids. A bunch of spending on bridges to nowhere and you get huge deficit cost and ultimately higher taxes or deficit costs. The key is identifying where capital is being applied efficiently and inefficiently. The rest is simple. It is, of course, an art form in identifying the key element here and mistakes will be made. This likely means that Obama is putting together the right approach. Do some tax cuts, do some spending increases, do some tax hikes and do spending decreases.
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4
I believe that the key argument that Krugman makes for spending is that a fraction of the outlay (Krugman uses 0.3) feeds back into the revenue stream in the form of taxes paid, so that effectively the outlay is only (1 - 0.3) what was originally spent. This is what provides for the greater bang for a buck of spending.
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5
Tax cuts can be good when they free up capital for more productive uses,
I have a problem with this at a time when the government is running massive deficits. the simple fact is that there is a source for an enormous amount of capital available at all times for "more productive uses".
Tax cuts, especially those that go in upper income levels, aren't applied to "more productive uses", rather they wind up simply inflating the value of pre-existing stocks and other investment instruments. Businesses DO NOT decide to create more jobs because they have more cash on hand -- they decide to create more jobs because they see an opportunity to sell more goods/services, and hire people in order to create those goods/provide those services. new jobs are created when demand for goods and services increases, and giving tax breaks for "job creating capital formation" doesn't work in the real world.
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We've seen this over and over -- not just with tax cuts for the rich, but with the Fed cutting interest rates to inject capital into the market -- Greenspan's "panic" rate cut didn't do a damn thing to stop the 2001 recession, because inventories were way too high, and productive capacity was sufficient to meet demand, so nobody was going to borrow money to create more capacity.
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While there does come a point where interest rates are too high, just as extremely high tax rates can prevent "job creating" capital formation. But those effects occur only in the more extreme cases -- when the P/E ratio on stocks and corporate bonds is significantly less than what you can get from the bank, then you need to reduce interest rates. But the last time that was going on was a couple of decades ago.... -
6
Thanks Justin,
This the best summary of the debate over the meaning of Christina Romer's research and the persistent ideological efforts by Greg Mankiw and others to missinterpret it. Good Job! -
7
plukasiak,
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I applaud your above post. Note that while I said tax cuts can be good when they free up capital for more productive uses I did not say which tax cuts nor did I mention which uses.
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Since the failed Reaganomics of trickle-down prosperity seems to have fallen off into the ditch, I have reformed my ways. I realize that it will not provide high-earners such as myself with tax relief, but if the consumer at large can't find a job, rebuild savings and buy within reason their wants and needs without excessive credit my prosperity will soon be doomed as well. While I came from a conservative stance, I am no idea hound. I suspect that atheism is out of vogue as well. -
8
Everyone seems to be ignoring the current mood of consumers in these debates. The Republicans in Congress are pushing tax cuts for small business. I work for a small business, and I can't believe our company could create jobs simply as the result of a tax cut. We primarily build process equipment, and our orders slumped with the drop in consumer spending.
So at first glance, a tax cut for consumers seems like a great idea. However, consumers seem to have figured out that they've been spending too much and saving too little in the last two decades. In with the current climate, I suspect they'd use the extra cash to pay off debts, or build their savings. (I know I'd just save more.) Giving tax cuts to consumers at the lowest income levels might be a good idea, since they're more likely to actually spend the cash. Of course, they won't be buying any new cars, appliances, boats, etc.
While tax cuts seem like a good idea, I have a hard time working out a mechanism whereby they can lead to job creation - at least without some substantial amount of concurrent government spending.
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9
Some posts say that Reagan and other tax cuts didn't work as if that conclusion came down with the Sermon on the Mount. Nice try - saying it doesn't make it so. It is not at all clear that Reagan tax cuts aka "trickle down" didn't work. That's the opinion of some, but many other reputable economists disagree. After all, Kennedy did it first back in the 60's, and it worked for him too.
As for Krugman, if a government dollar spent gets recycled, what happens to that tax cut dollar? There was a very good article by Robert Barro in the WSJ 3 or 4 weeks ago that calculated the multiplier of government spending to be approximately 0.0 (I think). One of the posters makes the point that his business can't take advantage of tax cuts now because the economy is so bad; my industry could still turn reduced taxes into increased employment. Tax cuts translate to almost immediate job creation in my industry, which would create disposable income immediately, which would be recycled just as well as, if not better than, Krugman's dollar spent.
As Mr. Fox indicates, the question is not that simple. I too like the idea of a little of each.
Anyway, the tax cut vs. spending question is largely irrelevant. The cause of the problem is the banking system breakdown and if we don't fix that the structure of the stimulus package won't matter. Obama and the Dems successfully blamed that 100% on Bush and the Republicans, which is totally ridiculous. Of course it is partly their fault, but that problem also belongs to Bill Clinton, Barney Frank, and the Dems. At the rate we're going, we're going to learn the wrong lessons, fix the wrong problems, and apply the wrong solutions because that's how we play politics these days.
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10
Let's see... if I spend $1.50 on a candy bar and sell it back to myself for $3.00, that means I just made a 100% profit! I'm gonna get rich! Woohooo!
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