Tax cuts Vs infrastructure spending

This post is in continuation to an earlier post on the two big macroeconomic debates of the present times. The first one had explored the debate between fiscal and monetary policies, while this one seeks to explore the debate within fiscal policy itself between tax cuts and government spending on public infrastructure.

Among the advocates of fiscal policy, there have been interesting debates about which among the various spending options are more effective - direct spending on infrastructure and works, tax cuts (and here to specific categories, especially those aimed at the poor and middle income than the rich and businesses), welfare assistance for the poor like food stamps and unemployment insurance, grants assistance for states etc.

However, on the larger canvas, this debate has become confined to a battle for supremacy between tax cuts and government spending on public infrastructure. It is argued that tax cuts are more likely to be saved or used to pay off debts, than spent. In contrast, infrastructure spending pushes money into the economy, with all its multiplier effect, besides creating public assets which in any case the government has to supply. The debate on this has revolved around the respective economic multipliers of these two stimulus alternatives.

Though tax cuts are a significant part of the proposed Obama fiscal stimulus, forming $150 bn each to businesses and individuals, its efficacy is extremely questionable, especially given the failure with the even the most recent experience with such tax cuts - the $146 bn tax cuts in February 2008 by the Bush administration (which was mostly saved or used to pay off debt).

The Romers (again!) are in the thick of this debate, having (allegedly) claimed in a recent NBER working paper that tax cuts have a multiplier of 3, as against the multipliers in the range of 1-2 for other fiscal spending alternatives (full article by Valerie A Ramey, whose research suggests a 1.4 multiplier for government spending, is available here).

Greg Mankiw makes out a list of all major citations that favour tax cuts as the most effective fiscal policy option, the most prominent being Andrew Mountfod and Harald Uhlig. Mankiw himself favours monetary policy over fiscal policy, but within fiscal policy prefers tax cuts over direct spending.

However, Nate Silver analyzed the Romers' position by drawing the distinction between two types of tax cuts - "exogenous" (one designed not to counter business cycles, but done under relatively healthy economic circumstances) and "countercyclical" (done in an unhealthy economy and designed to return the economy to normal growth) - and argues that the Romers were referring to the former, whereas the need of this hour is the latter.

Brad DeLong clarifies further on the differences between the two sets of figures. He writes that Ramey's study understates the spending multiplier, since it does not account for the inevitable increase in tax revenues from the spending. Krugman illustrates this effect nicely here, and Andy Harless here. WSJ's Real Time Economics, draws attention to an analysis by the forecasting firm Macroeconomic Advisers, which claims that the $775 bn Obama fiscal stimulus plan could "pay for up to 40% of itself via higher tax revenue over the next five years".

Interestingly, in an analysis of the employment creation potentials of the different stimulus programs of the US Government, Christina Romer and Jared Bernstein estimated (with "considerable uncertainty") the multipliers of government purchases (spending) and tax cuts at 1.57 and 0.99 respectively. It has to be said that with the available instruments and models, it is not possible to very accurately predict the multipliers associated with various policy alternatives. However, the weight of evidence clearly points towards government spending having a higher multiplier than tax cuts, especially when the economy is facing a recession.

There have been many other distinguished voices of support for government infrastructure against tax cuts. Paul Krugman (and here and here), Mark Thoma, Robert Skidelsky, Economic Policy Institute (EPI), Joseph Stiglitz - all have made strong cases against tax cuts and in favour of direct government spending.

Paul Krugman feels that those favoring tax cuts over government spending do so on ideological grounds, than based on any raitonal understanding of the issue. He lists out the opponents, all of whom are also incidentally political conservatives. He also clarifies on Gary Becker's support for monetary policy giving the example of the recession of early 1980s, arguing that unlike then, now we are kissing the zero-bound, where monetary policy becomes superfluous.

The other major issue between tax cuts and government spending is that the process of selecting the projects for fiscal spending may degenerate into a process of dispensing pork barrel, and hence deliver little bang for the buck. It may be questionable to reject an otherwise effective remedy just on the grounds of apprehension of being captured by vested interests. In any case, tax cuts too are vulnerable to similar inefficiencies, with the likelihood of dispensing tax cuts to those not in need of the same, who then end up saving it.

The debate between tax cuts and spending has overshadowed consideration of the other equally important fiscal policy options. Since recessions increase the numbers of those below the poverty line, increases in welfare assistance, by way of expanded coverage of food stamps and unemployment insurance, should ideally be one of the automatic fiscal stabilizers in the economy. It will improve the incomes of the poorest and leave them with cash to spend on other essentials. Stepped up assistance to states (who generally cut back on spending), increased allocation for ongaoing government infrastructure and other useful spending programs, release of money for delayed-but-in-progress works, and increase in easy to kick-start infrastructure projects.

There has also been the other big debate about how much fiscal stimulus is necessary to get normalcy restored as early as possible. Economists like Paul Krugman and Ben Stein have described that it is not possible to "nickel and dime our way" through the crisis facing us and have argued that normal rules do not apply during such extraordinary times. They claim that the output gap, between actual and potential GDP, is too high to be bridged with small or even medium tinkering, but requires shooting the biggest cannon with fiscal policy.

Adding his voice to this debate is Ben Bernanke, who in a recent speech, claimed that there was a need to pour billions more in cash infusions, over and above the $700 bn already committed in bailing out the financial markets, "to stabilize the financial system and restore normal flows of credit". He said that, atleast during extraordinary recessions, both monetary and fiscal policy responses converge on the need for a "surge" of infusions and government spending to even stand a semblance of chance to restore normalcy. But how much is needed appears to be far from settled.

Now after all this monetary and fiscal stimuluses, the economies show no signs of recovery. It is therefore not surprising that Ben Bernanke has now voiced his concerns that monetary policy should continue to go hand in hand with fiscal policy as desired policy response to such crises (he also dwelled on the need to strengthen regulatory over-sight immediately and co-ordinated action by nations in economic, financial and regulatory policies). A combined monetary-fiscal push, with the fiscal dimension assuming the lead, especially when we are well into a recession and when the zero-bound is on us (at zero-bound, the "crowding-out" from higher interest rates argument against fiscal policy loses steam), appears to be a more sensible way ahead. Bernanke had in a seminal speech in 2002, in response to the deflationary spiral that had trappen Japan, had argued that monetary policy still has an important role in a "deflation scenario", even when the interest rates hit the zero bound.

Update 1
Lawrence Mishell points to a study by Matthew D. Shapiro and Joel Slemrod (and here), which claim that only one-third of the $300 given back in tax credit early last year, as part of President Bush's $146 bn exclusively tax break fiscal stimulus, was spent, with the remaining having been saved or used to pay off debts. Mark Thoma too weighs in here.

Bruce Bartlett and Hal Varian make the case for a stimulus to boost private investment through tax concessions, which Mark Thoma counters.

Update 2
Edward Glaeser pumps for greater infrastructure spending.

Update 3
Justin Wolfers draws attention to a paper by Gauti Eggertsson of the New York Fed, which argues that at zero short-term nominal interest rate, tax cuts increase deflationary pressures and thereby reduce output. He reckons that tax cuts, by acting on the supply side (incentivizing them) by increasing labour supply and investments without simultaneously addressing the demand side, could actually exacerbate the crisis. So he prefers policies aimed at stimulating aggregate demand - a temporary increase in government spending and a commitment to inflate.

He writes, "The multiplier of tax cuts goes from positive at positive interest rates to negative once the interest rate hits zero, while the multiplier of government spending not only stays positive but becomes many times larger at the zero bound."
Justin Wolfers has this to say about tax rebate checks.

Update 4
Greg Mankiw compares the opposing views of Richard Clarida (Lower multipliers) and Christina Romer (higer multipliers) on fiscal stimulus measures.

Update 5
Greg Mankiw, quoting from the research by John F. Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland, claims that government spending multipliers are much smaller in New Keynesian modesl than in the older ones. Menzie Chinn replies here.

Update 6
CBOS estimates of the impact of the February 2008 tax cuts is discussed here.

Update 7
More on the debate here and here.

Update 8

If you want to cut taxes, cut them immmediately, and pre-empt anticipation effects that drags down economic activity.

Update 9
Robert Barro and Charles Redlick prefers tax cuts over government spending and finds that the multiplier of defence spending falls in a range of 0.6 to 0.8 and argues that non-defence multipliers are unlikely to be larger.

Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and find that - fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases; fiscal adjustments based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases; adjustments on the spending side rather than on the tax side are less likely to create recessions.

Update 10
Mankiw points to papers that find tax cuts superior to direct spending to combat recessions - Christina and David Romer, Alberto Alesina and Silvia Ardagna, Olivier Blanchard, Andrew Mountford and Harald Uhlig.