Friday, August 7, 2009

More on tax cuts Vs government spending

I had blogged earlier about the debate about the relative merits of tax cuts and government spending as fiscal stimulus measures. This blog has consistently argued that direct government spending programs pack a much greater punch in stimulating aggregate demand than indirect ones like tax cuts.

An IMF working paper by Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados, which studied the effects of fiscal policy response in 118 episodes of systemic banking crisis in advanced and emerging market countries during 1980–2008, finds that "timely countercyclical fiscal measures contribute to shortening the length of crisis episodes by stimulating aggregate demand".

About the superiority of government consumption over government investments and tax cuts, they write,

"The composition of fiscal expansions matters for crisis length - a point that has not been studied in the literature. Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment. A 10 percentage point increase in the share of public consumption in the budget reduces the crisis length by three to four months. Reducing the share of income taxes is less effective than consumption taxes in shortening the length of a banking crisis."

They also draw attention to the policy trade-off between measures to stimulate short-run aggregate demand that impacts output and employment relatively fast, and delayed (public investment-driven) stimulus that has a larger impact on productivity and economic growth,

"The quality of the fiscal stimulus package matters most for post-crisis growth resumption, with fiscal responses relying largely on scaling up the share of public investment in the budget showing the largest positive effect on medium-term output growth. A one percent increase in the share of capital outlays in the budget raised post-crisis growth by about one-third of one percent per year. Income tax reductions are also associated with positive growth effects."

And of relevance to fiscally constrained countries like India,

"Initial fiscal conditions matter for fiscal performance during shocks. In countries with high pre-crisis ratios of public sector debt to GDP, lack of fiscal space not only constrains the government's ability to implement countercyclical policies, but also undermines the effectiveness of fiscal stimulus and the quality of fiscal performance. In countries with high debt, crises lasted almost one year longer. The effect of high public debt on duration completely offset the benefits of expansionary fiscal policies in these countries...

These findings point to the importance of creating fiscal space and enhancing macroeconomic stability in tranquil times to limit the risk of falling into crises and to enhance the effectiveness of policy responses when exogenous shocks hit countries... fiscal policy responses may not be effective when initial fiscal conditions are poor and fiscal space is limited. High public debt levels and past macroeconomic instability limit the scope for countercyclical deficit expansions and hamper the effectiveness of fiscal stimulus measures as markets perceive the higher future fiscal risks entailed by larger deficits"

Menzie Chinn points to an excellent IMF staff poistion note that summarizes the fiscal policy responses across the globe and makes projections about the fiscal positions of these countries. Among the G-20, it estimates fiscal deficits in both 2009 and 2010 to be 5.5% of GDP above their pre-crisis (2007) levels. Of this, crisis-related discretionary measures is estimated to be 2% of GDP in 2009 and 1.6% of GDP in 2010, with the rest of the change in fiscal balances reflecting primarily the automatic fiscal stabilizers and revenue losses associated with extraordinary declines in asset and commodity prices.

It finds government spending — either for consumption or investment — more effective than cutting taxes,

"While government spending results in a direct increase in aggregate demand, tax cuts might not be fully spent (although increased saving may have a beneficial impact over the medium term in repairing household balance sheets). The IMF’s Global Integrated Monetary and Fiscal Model (GIMF) yields low fiscal multipliers for cuts in labor taxes and lump-sum transfers (0.2–0.5); and high multipliers for government expenditure (1.6–3.9) and targeted transfers (0.5–1.7). Zandi (2008) finds larger fiscal multipliers for infrastructure spending and targeted transfers (1.7) than for general tax cuts (0.3). Finally, a 2003 UK Treasury study based on the European Commission’s QUEST model finds larger one-year fiscal multipliers for government spending (0.3–0.7) than for tax cuts (0–0.3). This said, as noted earlier, it often takes long to activate spending without wasting public resources, especially for new programs."

As Mark Thoma points out, tax cuts work in two ways. First, if they are spent and not saved or used to repay debts, this spending "stimulates aggregate demand, output, and employment". Second, if saved or used to repay off debts, it helps "refill damaged balance sheets" and thereby "shorten the length of recessions". He argues in favor of a portfolio of fiscal stimulus policies - government investment, government consumption, and tax cuts. I fully agree with his summary of the debate and his finding that though the US fiscal stimuluses contained more than enough measures devoted to long-run economic growth, it had far too few devoted to simulating aggregate demand immediately,

"Tax cuts on consumption and government consumption have a relatively immediate impact both on aggregate demand and on the rate at which balance sheets are repaired, and income tax cuts along with spending on infrastructure are better at enhancing long-run growth... tax cuts can help to shorten recessions as described above, and this effect occurs both because tax cuts help to repair balance sheets when the tax cuts are saved, and because they stimulate consumption. But the effectiveness of the tax cuts in the short-run could have been improved by targeting consumption rather than income, and government consumption may have had an even larger effect."

Gary Burtless highlights the achievements of the fiscal stimulus in the US that in the six quarters since the end of 2007 transferred more than $830 billion to Americans’ personal disposable income through personal tax payments and social insurance contributions. Transfer payments to households increased $382 billion, or 22%.

Update 1
Miguel Almunia, Agustín S. Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua (full paper here) gathers data on growth, budgets and central bank policy rates for 27 countries covering the period 1925-39 and shows that where fiscal policy was tried, it was effective. They find fiscal multipliers as large as 2 in the first year, before declining significantly in subsequent years.

In the absence of adequate awareness and knowledge about fiscal policy and with Central Banks too closely tied up with the Gold Standard, governments generally followed conservative policies to combat the Depression. Japan and Italy were exceptions.

They also find that contrary to widespread belief that monetary policy is ineffective in near-zero-interest-rate (liquidity trap) conditions, in the 1930s it accommodating monetary policy helped, by transforming deflationary expectations and by helping to mend broken banking systems.

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