Sunday, September 5, 2010

Fiscal multipliers for tax cuts and spending

I have blogged here and here about fiscal multipliers for different policy choices. Among the different fiscal stimulus spending choices, there is heated debate on the relative effectiveness (in terms of its bang for the buck or fiscal multiplier) of tax cuts and direct spending.

In the US, with the controversial Bush original tax cut in place since June 2001, set to expire by end of this year, there is an intense debate raging about its future. Republicans expectedly want them to continue and made permanent, whereas Democrats are broadly converging to the view that it should expire for those with incomes beyond $250,000.

Mark Zandi has this revised and latest examinaton of the fiscal multipliers of various stimulus measures.

As can be seen, direct government spending - through unemployment benefits, food stamps, work sharing or infrastructure spending - top the list, giving more than a dollar's worth of stimulus for a dollar's worth of spending, while cuts to taxes affecting businesses and upper-income individuals - such as the corporate, dividend, capital gains and alternative minimum taxes - gives much less.

However, since tax cuts are politically easier to push through, tax rebates aimed at those likely to spend (as against save it), jobs tax credit to spur investment and hiring, and cuts in payroll tax (which finances Social Security and Medicare and is paid by both businesses and workers) may be the most effective.

See also this paper by Alan Auerbach and Yuriy Gorodnichenko who find that "large differences in the size of fiscal multipliers in recessions and expansions with fiscal policy being considerably more effective in recessions than in expansions" and that "controlling for predictable components of fiscal shocks tends to increase the size of the multipliers".

Update 1 (25/9/2010)

Analysis show that the 2008 Bush tax cuts failed.


Sai Prasad said...

I would be very happy to see such multipliers being worked out for India and the states. In fact, i would like to see finance departments sweat it out a little bit, instead of simply limiting themselves to expenditure contriol.

It would be very interesting to see the methodology adopted for estimating such multipliers and the assumptions made therein. The reliability of the multipliers would depend a lot on such assumpions.

As far as we are concerned it would be easy to push through both tax cuts and direct spending for the poor. We would naturally like to spend a lot without taxing our folks, if we can manage the same.

gulzar said...

i completely agree with you.

in fact, far from using hard evidence from empirical investigations, our departments support specific programs (against others) based on anecdotal evidence or intuitive logic. in fact, finance departments should force individual line departments to submit their spending proposals (why scheme A is preferable to scheme B or C) based on scientific assessments of multipliers.

since both tax cuts and direct spending are populist, the challenge for us would be to spend money where it would generate the biggest bang for the scarce buck. and multipliers have a major role to play here.

in India's context, it may also be appropriate to additionally focus on the employment generation potential of the investments proposed.