Federal Spending Gives More Bang-for-Buck than Tax Cuts

Personal saving rose again in the second quarter. “Does this mean the stimulus tax cut has failed, as the 2008 tax cut stimulus did?”, asks The National Journal.

My answer:

Martin Feldstein and others predicted that the tax-cut component of the 2009 fiscal stimulus package would have substantially less expansionary bang-for-the-buck than the spending component of the package, because much of the tax cut would be saved, as had been the case with the 2008 tax cut. (“Bang for the buck” in this case could be defined as demand stimulus divided by budget cost.) We knew this from Milton Friedman’s permanent income hypothesis, or even from good old Keynesian multiplier theory. But in February, President Obama had to get those last three (Republican) votes for the bill in the Senate, and those three Senators insisted on raising the tax cut component of the stimulus package a bit and lowering the spending component. Their motivation presumably was to mollify their fellow Republicans, many of whom still claim that ONLY tax cuts provide stimulus, and that spending does not (and perhaps even has a negative effect) — which is even more extreme than the claim that a tax cut creates stimulus equal to spending. After the failures of the Bush tax cuts (and Reagan’s before him), I don’t know if any economists still cling to such “supply sider” notions — or indeed if these congressmen would be able to state their logic. Regardless, I think the Feldstein prediction has been borne out since then.

Fortunately, the majority of the stimulus package took the form of increased spending, much of which has yet to come.

None of this is to deny that efficiency is an important consideration, and cost-benefit calculations should always enter into the choice of both what kind of tax cuts to adopt and what kind of spending increases to adopt. But if it is short-term demand stimulus we are after, and we are, then government spending gives more bang for the buck than tax cuts.

Comments

[The Geoffster:]

What do Keynes and Feldstein say about stimulating the economy with borrowed money that can never be paid back?

Aug 04 09:34 AM

[Andrea Gian...:]

I guess Keynes would say simply that.. in the long run we are all dead. :)


On Aug 04 09:34 AM The Geoffster wrote:

> What do Keynes and Feldstein say about stimulating the economy with
> borrowed money that can never be paid back?

Aug 04 10:36 AM

[Tony Petroski:]

The author quotes Feldstein: "Martin Feldstein and others predicted that the tax-cut component of the 2009 fiscal stimulus package would have substantially less expansionary bang-for-the-buck than the spending component of the package, because much of the tax cut would be saved, as had been the case with the 2008 tax cut."

That's exactly what Professor Walter Heller told us undergraduates in 1980. He called it the "leaky bucket" theory. Government spending was more stimulative because "government will spend all the money while people getting tax breaks will save part of it." Now granted, that savings rate is very small, but the key flaw in the Heller/Feldstein argument is to equate all spending in a neutral fashion. Picture a wise father planning to borrow money in order to benefit the local economy. He has two sons, "Nose to the Grindstone" and "Party Hardy." Does the wise father give all the borrowed money to Party Hardy because he knows Party Hardy will spend all of it rather than Nose to the Grindstone who will save an invest part of it? The "multiplier effect" should be much greater through the spending of Party Hardy rather than Nose to the Grindstone.

Heller was wrong on the tail end of the Carter Malaise years and he missed out completely on the Reagan Revolution. It's fascinating to see those old arguments resurrected.

Don't get lost with a money illusion. Pardy Hardy will produce more "stimulus" in the short run, the very short run, as the number of bars, whiskey factories and poker games get larger. The cash for clunkers program is producing a similar "stimulus" as we destroy perfectly good vehicles in order to pay people to buy cars that they would have bought anyway. Always keep in mind that the goal of an economy should not be to gin up GDP numbers in the short run and inflate the numbers of "employed" by putting shovels in their hands so they can open up holes and fill them in again. The goal of an economy is to maximize production of useful goods and services while conserving the ones you already possess.

Aug 04 10:47 AM

[CautiousInv...:]

Spending is not spending.

The stimulus and investment package is nothing more than a very expensive thank you to those that helped Obama get elected.

Most recently it was revealed that Apollo Alliance sent a blue print of the ideal stimulus package to congress; more worrisome, it was read and Reid thanked the group for its efforts. With heavy links to ACORN, SEIU and green groups, you can imagine the tilt to their idea what comprises stimulus.

With Pelosi, Reid and the Apollo Alliance serving as architects of this massive spending bill, I'm confident history will record it as the most corrupt and wasteful measure ever passed by an increasingly
craven congress held hostage by special interests.

Aug 04 11:13 AM

[Sloped Mind:]

The reason for the recession was not a sudden irrational increase in the personal savings rate, and any recovery that happens without an increase in the savings rate would have been short lived, since consumers would eventually try to rebuild their balance sheet after the housing crash, creating a double dip recession.

During much of the 21st century, people have defined the increasing values of their homes as part of their savings. With this component gone, an increase in the savings rate was a very obvious event. This could either happen through a double dip creating pullback in consumer spending as the government stimulus runs out, or it could happen before the government purchases even kick in, through savings built from tax cuts.

For government spending to lead to a sustainable recovery, you need to make sure that consumers will play along. By resetting their savings rate, the tax cuts have been the most important part of the stimulus package, in that it has created the necessary foundation for any sustainable recovery.

The government spending that is yet to come online with help create a stronger recovery, but most of it will come online as the economy is already growing at or near potential.

Aug 05 02:20 AM

[Gregman2:]

Obviously, debt can be used to create wealth. But it's not happening now in the private sector, really. It's being used to finance ops. By the way, isn't income usually a precondition to receive a tax cut? I thought real incomes were in decline. (At least, most small businesses I talk to say they're not making any money, and are just "treading water.")

Aug 05 10:50 AM