Stimulating Output: What can fiscal policy do?

In a comment on this post, Lisa asked

What would effective government spending by the Obama Administration look like? Is it providing targeted tax credits? Or are there specific infrastructure plans that might work in the short-run to stimulate the economy? What would an effective economic stimulus plan look like?

Lisa asks the right questions. Here are my thoughts on government stimulus and what Obama can do if he wants to stimulate the economy.

What can the government do to stimulate the economy? Not much, at least not directly. The government faces two fundamental problems:

1. Government spending reduces resources available to the private
sector. And, of course, every penny the government borrows to pay for
those resources must be repaid by that same private sector.
2. To be stimulative, government spending has to occur when the
economy is getting worse not when it is recovering.

Government Spending Reduces Resources: This is essentially the “crowding out” argument and I am aware that this point is hotly debated amongst economists. (See Nobel Laureate Paul Krugman for a strong proponent of the other side. We disagree in this case but he is one of the best economists around and he is worth a listen.)

The argument gets complicated and people start drawing IS-LM curves but here is the simple way to think about it. The amount of goods and services available in the economy at any moment in time is essentially fixed. If they government takes some of those goods, whether it’s steel to build a bridge to nowhere or paper to bind the thousand-page report on its policy, those goods are gone. They are no longer available to the private sector.

If somebody wants the steel, they have to outbid the government. In general, no private-sector firm can outbid the government and so they must outbid another firm: one of them loses and can’t complete their project.

The increase in price caused by government intervention can prevent price adjustment in key sectors. Booms are characterized by some goods becoming overpriced and busts are characterized by some goods falling in price. This price adjustment must occur for the economy to recover. Imagine how long adjustment might have taken if the government had tried to maintain the price of the fiber optics networks during the 2001 recession.

In addition, the government is distorting the amount of goods available for private consumption today relative to what is available in the future. As a result, interest rates rise. (This rise in interest rates is exactly what Krugman is going for when he recommends fiscal policy as a way out of a Liquidity Trap, a subject I will return to in a future post.) The increase in the real interest rate reduces private investment across the board. Investment is lower even in industries whose inputs the government is not consuming.

Government Spending Must be Well Timed: The crowding out effect always exists but the gains of government spending may outweigh the costs if the spending is implemented during the downturn. As a rule, the government should only interfere in the economy when it can do something better than the private sector and when the rate of return on that something is higher than the private rate of return.

As the economy enters recession, the rate of return on private investment is low. The probability of the government’s rate of return exceeding the private rate is higher. This return advantage disappears as the economy begins to recover.

Large spending programs take a long time to implement, making it difficult to time the downturn.

What Should the Government Do? The above problems are one of the reasons economists like tax cuts as stimulus. In a sense, a tax cut is not stimulating the economy but is removing a distortion that keeps the economy from growing. A tax cut send a relatively small amount of money to a relatively large number of people. At least some of these people will be able to respond to the cut. With an investment tax cut, some business is ready to build. With a consumption tax cut, some household is ready to buy that new water heater.

Choosing the right tax cut is tricky. Cutting investment taxes or dividend taxes, yet again, is probably not going to work. The return on investment is low at the moment; the marginal increase implied by the tax cut likely won’t matter. Plus, the Bush administration has already milked this cow.

In my mind, the best place to cut taxes right now is on labor income. Right now firms don’t want to hire labor because it is too expensive. Likewise, some workers don’t want to take a pay cut and so may not be working. Cutting the income tax is an easy way to hit this margin.

The problem with this plan, according to common lore, has always been that most workers don’t actually pay much income tax. This logic, however, is wrong. Every worker in the country pays the regressive FICA (social security) tax. This tax amounts to about 14 percent of income for low-income workers.

Suspending this tax works on two margins. First, taxes are cut on the group that appears to be struggling the most. Those who are struggling the most are also the most likely to spend the money in the near term. Second, with this tax lower, workers want to work more and firms want to hire more.

What Can the Government Do Without Cutting Taxes? Well, the same principal can be used with the states. Any substantial increase in infrastructure or education program is actually implemented at the state or municipality level. Give every state something like $2 billion dollars and make the transfer expire at the end of the year. I guarantee those states can find a use for the money. Some of the states will repair roads and bridges or they may use the money to implement already pending projects. Others will build schools or rebate the transfer to their own citizens. It does not matter. The state will use the funding in a manner that works best for them.