Hoover Daily Report

Three Views of the 'Fiscal Cliff'

via Wall Street Journal
Sunday, May 20, 2012

Discussion of the so-called fiscal cliff—the combination of tax increases and spending cuts that will come in 2013 if Congress and the president don't act—confuses a number of different issues. The evidence suggests that we should fear the tax hikes, but not necessarily the spending cuts.

Anyone who uses the term "fiscal cliff" accepts a Keynesian view of the economy, knowingly or not. Both tax increases and constrained spending are assumed to be bad for the economy.

But there are two other views: that of the budget balancer and that of the supply-sider. Rather than term the impending changes that will occur in 2013 a "fiscal cliff," the budget balancer thinks of this as "fiscal consolidation." Tax increases reduce the deficit, as do cuts in government spending. Both are austerity measures that make the government more responsible and, therefore, both are conducive to long-run economic growth.

Those who support the Simpson-Bowles plan subscribe, at least in part, to this view. Various proponents of the plan may place different weights on the tax-increase side or the spending-decrease side because they believe the economic consequence of one or the other is more adverse. But fundamentally, the target is to decrease the deficit. The budget balancer regards both tax increases and spending cuts as moves in the right direction.

The supply-sider has a different view from both the Keynesian and the budget balancer. Fundamentally, supply-side advocates focus on the harmful effects of tax increases. Raising tax rates hurts the economy directly because tax hikes reduce incentives to invest and because they punish hard work. As such, tax increases slow growth. But budget cuts work in the right direction by making lower tax revenues sustainable. If spending exceeds revenues, then the government must borrow and this commits future governments to raising taxes in order to service the debt.

Consequently, the supply-sider thinks of 2013 primarily as a tax increase and fears what that will do to the economy. The spending cuts are a positive. Unlike the Keynesians who view the fiscal cliff as being bad on two counts, or the budget balancer who views it as being good on two counts, the supply-sider scores it one-and-one. The tax increases have negative effects on the economy; the controls on spending are a positive side effect of the 2013 sunsets.

Which of the three views is correct? Until recently, most economists believed that fiscal policy was inappropriate for business-cycle management, and that if stimulus was needed at all, monetary policy was the best way. Spending "stimulus" does not have a strong track record in recent decades. There is more ambiguity now about the choice between monetary and fiscal policy, in large part because with interest rates near zero, the effectiveness of monetary policy is thought to be more limited.

But even if a fiscal stimulus has some benefit, the cost of fiscal policy is likely to be very large. In order to stimulate the economy, growth in—not high levels of—government spending is required. To provide a stimulus in 2013 comparable to the 2009 legislated stimulus, we would need to increase government spending by about $250 billion.

But the Keynesian view implies that keeping spending constant at the higher level in 2014 would generate no stimulative growth effect for 2014. Despite the higher level of spending in 2014, we would get no additional growth because there is no increase in spending over the 2013 level. Were we to retreat to current levels of spending, there would be a contractionary effect on the economy as government spending decreases. If we want to delay our day of reckoning, we must keep spending at a higher level for each year that we want to postpone the negative consequences for growth. Given the state of the labor market, this could mean a few years. If we waited four years, we would spend $1 trillion to get $250 billion in stimulus.

On the tax side, there is strong evidence that supports the supply-siders. Christina Romer, President Obama's first chairwoman of the President's Council of Economic Advisers, and David Romer document the strong unfavorable effect of increasing tax rates on economic growth (American Economic Review, 2010). They report that an increase in taxes of 1% of gross domestic product lowers GDP by almost 3%. The evidence on government spending also suggests that high spending means lower growth.

For example, Swedish economists Andreas Bergh and Magnus Henrekson (Journal of Economic Surveys 2011) survey a large literature and conclude that an increase in government size by 10 percentage points of GDP is associated with a half to one percentage point lower annual growth rate.

The evidence suggests that we should move away from worry over the impending "fiscal cliff" and focus more heavily on concern about raising taxes. And although some Keynesians may view this as not the best time to control spending growth, promising to change our ways in the future is as credible as Wimpy's promise to pay on Tuesday for the hamburger that he eats today.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-2009, is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.