Saturday, December 19, 2009

"Paradox of toil"

One of the most interesting policy debates during the current recession has been over the most effective fiscal policy options to combat the situation. Broadly, the divide has been over which of the two types of policy alternatives - tax cuts and direct spending measures - is superior.

Supporters of tax cuts claim that tax cuts increases the disposable incomes in the hands of individuals and firms and thereby incentivizes them to consume and invest, and is therefore the least distortionary of options. They also point to the relative ease of implementing tax cuts against the well knwn lags in direct spending measures.

However, the supporters of tax cuts may have overlooked the fact that while tax cuts may be an effective (even the better) policy during a normal recession, it may not be an appropriate remedy for the present times. The current recession is exacerbated by the zero-bound induced liquidity trap, which sets in motion a set of rational expectations that are likely to end up perversely affecting indirect measures like tax cuts. In view of the fact that recessions which come along with a zero-bound in interest rates are very rare (the only major such recession being the one faced by Japan at the turn of the century), all available literature examine only the regular economic contractions.

Paul Krugman points attention to a paper by Gauti Eggertsson that examines the types of fiscal policies that are effective at zero interest rates and finds that direct spending policies score over tax cuts. Eggertsson's model finds that when the economy is facing the zero-bound (liquidity trap), tax cuts, on both capital and labor incomes, are contractionary and deflationary spiral takes hold.

Standard New Keynesian models have long argued that when an economy is faced with liquidity trap, tax cuts on capital income unleashes rational expectations that encourages people to save the additional income instead of investing it - paradox of thrift. In Eggertsson's model, cutting taxes on labor income expands labor supply, and puts downward pressure on wages. The resultant deflationary expectations increases the real interest rates and lowers both output and employment. A "paradox of toil" is the result!

Fundamentally, at zero-bound, the economy faces insufficient demand and therefore only fiscal policies that directly stimulate aggregate demand can succeed. Such policies include a temporary increase in government spending and tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply (such as an investment tax credit or a cut in sales taxes). Greg Mankiw recently advocated investment tax credits to incetivize businesses to invest.

The contractionary effect of tax cuts is understandable given the fact that they have no direct effect on consumption spending and investment. The labor and capital income tax cuts increases the supply of disposable incomes in the hands of individuals and businesses respectively, incomes which they can either save, use to pay off debts, or spend/invest. In the prevailing conditions - deflationary and recessionary - both consumers and businesses are more likely to either save or pay off debts, than spend or invest.

Eggertsson's verdict on the debate is fairly conclusive,

"Policy makers today should view with some skepticism empirical evidence on the effect of tax cuts or government spending based on post-WWII US data. The number of these studies is high, and they are frequently cited in the current debate. The model presented here, which has by now become a workhorse model in macroeconomics, predicts that the effect of tax cuts and government spending is fundamentally different at zero nominal interest rates than under normal circumstances."

See also Casey Mulligan's take on the "paradox of toil", one that again ignores the specific circumstances.

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