Tuesday, December 15, 2009

Fiscal Stimulus – Spending Increases v. Tax Cuts

Greg Mankiw thinks we should try a different kind of fiscal stimulus than the one passed earlier this year. Of course, the one passed earlier this year was a mix of spending increases and tax cuts (see for example Nate Silver). Some of us argued that including tax cuts lowered the bang for the buck from the stimulus package but Greg disagrees:
Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending.

Greg is citing evidence from periods when the interest rate was positive. Gauti Eggertsson asks What Fiscal Policy Is Effective at Zero Interest Rates? His abstract reads:
Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today.

This is immediately followed by table one showing a government spending multiplier equal to 2.27 whereas the labor tax multiplier is negative 0.81. Hat tip to Paul Krugman.


Anonymous said...

I took the opportunity to read one of the papers cited by Mankiw: Mountford and Uhlig. First, I don’t buy their method of identification for a minute, as it imposes strong theoretical exclusion restrictions. In labor economics, a paper like this wouldn’t have made it out of a seminar.

Anyway, in the paper, Mountford et al. examine “… US quarterly data, [sic] from 1955 to 2000.” To take a simple example, the current overnight federal funds rate is 0.12, which has prevailed for the past year, with a target rate of 0 to 0.25. Over the time period examined in the paper, there was a brief period–May 1958–when the rate approached this level. And it did so for less than a week. The results of the Mountford et al. paper, even if I were to buy the identification strategy, still wouldn’t matter in today’s ZIRP world. They do, however, help Mankiw to muddy the waters, so they shouldn’t be dismissed outright.

Anonymous said...

How long before we find out a tax INCREASE on wages stimulates the economy? Yes, tax the heck out of people, offer them no relief, and, above all, never admit paying off debt also counts as savings.

Sandwichman said...

Model, schmodel. The results of ANY model is based on a whole bunch of ASSumptions.

Myrtle Blackwood said...

"Fiscal policies aimed directly at stimulating aggregate demand work better. . ."

The assumption, of course, is that the economy operates in the context of a deficit of aggregate demand.

In the 'real' world there exists major shortages of supply. In:

* water for irrigation of crops;
* arable land for food production;
* energy in general;
* a variety of minerals;
* global fish stocks;
* time to fix the climate change/ocean acidification/biodiversity crises.

How long will it be before economists stop talking in undifferentiated terms such as 'fiscal stimulus' and 'aggregate demand'. What is the meaning to be found here?

[Human beings don't suffer from a shortage of demand for things. So which entity is being catered for here in this language? 'Economic man' or 'biological man' (a living being dependent on the life support mechanisms of a limited bioshpere)? The latter has an oversupply of demand for the earth's resources.]

TheTrucker said...

Much thanks to Krugman for waking me up to the fact that "capital income" to a FED economist includes income from T-Bills and mortgages and is not specifically a "capital gains" income or even a "dividends" income.

In my own silly world "capital" is actual productive _stuff_ as opposed to T-Bills. If we differentiate capital gains (gains from investing in productive enterprises) from other forms of "capital income" such as interest on T-Bills then Gauti's proposition concerning cuts to taxes on "capital income" _COULD_ (and probably would) be absolutely true. I think I am in Gauti's camp here if he is talking about INCREASING taxes on "interest" income (which to a FED economist is "capital income") while leaving "capital gains" tax rates as is.

Even so, I am not real sure what a "liquidity trap" has to do with the differentiation between returns to _real_ capital investment, and the stuffing of money into a T-Bill mattress. What matters is the different tax rates imposed on these two different "capital incomes".

But I am at a loss on the wage tax deal.

The supply of AMERICAN labor is what it is in the short term and no amount of tax fiddling is going to change it. A reduction in wage taxation will increase the opportunities for AMERICAN wage earners even if it reduces the return to innovative capital investment. Is this innovation thing his angle???

TheTrucker said...

OOPS!!!! My brain is not workin! If a money holder achieves a gain in the value of the money due to deflation then there IS NO TAX ON THE INCOME. That _IS_ a liquidity trap (for me at least), and only government spending tons of money into the economy thus _CAUSING_ inflation will work. Absent inflation there is no tax on money or T-Bills. No tax on "hoarding" money.

devin said...

"How long before we find out a tax INCREASE on wages stimulates the economy?"

Well, it seemed to work during WWII.

Even for those who deny the New Deal improved things during the Great Depression, there's still that annoying fact that from the standpoint of taxation and government spending, WWII was simply the New Deal on steroids. And it worked.

Myrtle Blackwood said...

"WWII was simply the New Deal on steroids. And it worked."

Worked for whom?

What intergenerational effects did the wholesale use of non-renewable resources have. What part did the this war play in raising greenhouse gases in the atmosphere?....Or was that a tongue in cheek response, Devin?