Hold the High Ground

Tuesday, March 29, 2011

Not long ago, President Obama and congressional leaders were confronting calls for four key fiscal decisions: short-run fiscal stimulus, medium-term fiscal consolidation, long-run tax reform, and entitlement reform. The president sought more spending, especially on infrastructure, and higher tax rates on income, capital gains, and dividends (by allowing the lower Bush rates to expire). The intellectual and political left urged him on, arguing that the failed $814 billion stimulus in 2009 was too small and that controlling spending any time soon would derail the economy.

But economic theory, history, and statistical studies reveal that more taxes and spending are more likely to harm than help the economy. Those who demand spending control and oppose tax hikes hold the intellectual high ground.

Writing during the Great Depression, John Maynard Keynes argued that “sticky” wages and prices would not fall to clear the market when demand declines, so high unemployment would persist. Government spending produces a “multiplier” to output and income; as each dollar is spent, the recipient spends most of it, and so on. Ditto tax cuts and transfers, but the multiplier is assumed to be smaller.

Macroeconomics since Keynes has incorporated the effects of longer time horizons, expectations about future incomes and policies, and incentives (including marginal tax rates) on economic decisions.

Temporary small tax rebates, as in 2008 and 2009, result in only a few cents per dollar in spending. The bulk (according to economists such as Franco Modigliani and the late Hoover senior fellow Milton Friedman) or all (according to Hoover senior fellow Robert Barro of Harvard) is saved, as people spread any increased consumption over many years or anticipate future taxes necessary to finance the debt. Empirical studies (such as those by my Hoover colleague Robert E. Hall and Rick Mishkin of Columbia University) conclude that most consumption is based on longer-term considerations.

The best economic evidence testifies against increased spending and increased taxes. Preventing tax hikes would be the best stimulus.

In a dynamic economy, many parts move simultaneously and it is difficult to disentangle cause and effect. Taxes may be cut and spending increased at the same time, and those steps may coincide with natural business-cycle dynamics and shifts in monetary policy.

Using powerful statistical methods to separate these effects in U.S. data, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago conclude that the small initial spending multiplier turns negative by the start of the second year. In a new cross-national time-series study, Ethan Ilzetzki of the London School of Economics and Enrique Mendoza and Carlos Vegh of the University of Maryland conclude that in open economies with flexible exchange rates, “a fiscal expansion leads to no significant output gains.”

Hoover senior fellows colleagues John F. Cogan and John B. Taylor, with Volker Wieland and Tobias Cwik, demonstrate that government purchases have a GDP impact far smaller in New Keynesian than in Old Keynesian models and quickly crowd out the private sector. They estimate the effect of the February 2009 stimulus at a puny 0.2 percent of GDP as of December 2010.

By contrast, the last two major tax cuts—President Reagan’s in 1981–83 and President George W. Bush’s in 2003—boosted growth. They lowered marginal tax rates and were longer lasting, both keys to success. In a survey of fiscal policy changes in the Organization for Economic Cooperation and Development over the past four decades, Harvard’s Alberto Alesina and Silvia Ardagna conclude that tax cuts have been far more likely to increase growth than has more spending.

Temporary, small tax rebates, as in 2008 and 2009, result in only a few cents per dollar in spending.

Former Obama adviser Christina Romer and David Romer of the University of California, Berkeley, estimate a tax-cut multiplier of 3.0, meaning that $1 in lower taxes raises short-run output by $3. Mountford and Uhlig show that substantial tax cuts had a far larger impact on output and employment than spending increases, with a multiplier up to 5.0.

Conversely, a tax increase is very damaging. Barro and Bain Capital’s Charles Redlick estimate large negative effects of increased marginal tax rates on GDP. Alesina and Ardagna also conclude that spending cuts are more likely to reduce deficits and debt-to-GDP ratios, and less likely to cause recessions, than tax increases.

These empirical studies leave many leading economists dubious about the ability of government spending to boost the economy in the short run. Worse, the large long-term costs of debt-financed spending are ignored in most studies of short-run fiscal stimulus and even more so in the political debate.

Uhlig estimates that a dollar of deficit-financed spending costs the economy a present value of $3.40. The spending would have to be remarkably productive, both in its own right and in generating jobs and income, for it to be worth even half that future cost. The University of Maryland’s Carmen Reinhart, Harvard’s Kenneth Rogoff, and the International Monetary Fund all conclude that the high government debt-to-GDP ratios the United States is approaching damage growth severely.

Even sophisticated modeling has difficulty capturing the complexity of a dynamic market economy (an idea stressed by Friedrich Hayek and Robert Solow). But the best economic evidence indicates we should reject increased spending and increased taxes. Preventing tax hikes would be the best stimulus.

If anything, we should lower marginal effective corporate and personal tax rates further (for example, along the lines suggested by the bipartisan deficit commission’s Erskine Bowles and Alan Simpson). We should quickly enact an enforceable gradual phase-down of the spending explosion of recent years. That’s what the president and congressional leaders should initiate. Then the equally vital task of long-run tax and entitlement reform can proceed.