Just before Christmas the House passed the Senate's two-month extension of the payroll-tax holiday, raising workers' paychecks by two percent for the next two months. Republicans in the House initially objected to the measure, insisting that the extension, if there must be one, should be for a full year rather than having another showdown in just two months. Republicans also argued that if saving Social Security was really a concern of Democrats, then it doesn't make any sense to divert funds away from Social Security in the first place.
From an economic perspective, the Republicans were correct, even if they came out losers from a political perspective. Tax cuts that are permanent work much better than temporary tax cuts.
Traditional Keynesian economics posits that when consumers receive higher income in the form of a tax cut, they save a fraction of it but spend the rest. That additional spending further stimulates the economy, providing a multiplier effect. For example, Mark Zandi's model suggests that temporary tax cuts boost the economy by $1.29 in the first year for each $1 in cuts (see Table 3 here). On the other hand, permanent tax cuts only increase GDP by about $0.51 in the first year for each $1 in cuts according to his model.
However, the evidence on temporary tax cuts is much less supportive than large-scale macro models suggest. A recent paper by Sahm, Shapiro, and Slemrod (here) uses survey response data based on the Consumer Expenditure Survey and the University of Michigan Survey of Consumers to examine the responses to the 2008 lump-sum stimulus payment and the 2009 temporary tax cuts; and it reviews similar survey research done after the 2001 lump-sum tax credit and 2003 tax cut. Quoting from their conclusion (p. 29), "All in all, none of the policies implemented in 2008 and 2009 to increase disposable income was very effective on a per-dollar basis in stimulating spending in the near term." They do point out that the effectiveness of temporary tax policy changes does depend on the economic environment, consumers' balance sheets (how indebted they are), and how the stimuli are distributed (one-time payments versus changes in withholding). Nevertheless, the evidence suggests that temporary tax cuts do not work well.
Milton Friedman's Permanent Income hypothesis, lifecycle models like those of Peter Diamond, and the concept of consumption smoothing all help to explain the discrepancy. Basically, all these ideas boil down to the idea that consumers like to maintain a constant level of consumption over time. Most people prefer not to live in a mansion one year and a mobile home the next year; they try to maintain a similar lifestyle over time. Thus, a temporary tax cut will not cause them to go out and spend a lot more. Instead, they may spend a small portion of the tax cut, but for the most part they will just save the money, rather than have a volatile stream of consumption. On the other hand, a permanent tax cut, by definition, implies that income will be higher for all future periods than it would have been prior to the cut. Therefore, the household can increase consumption and maintain that higher level of consumption over time -- they won't need to reduce consumption again as they would if the tax cut were temporary.
Keynesian models are not very good at incorporating peoples' beliefs about their future income, and that's why these models overstate the impacts of temporary tax cuts.
Of course, some consumers are constrained by debt or else already struggling to get by. Those consumers would be more likely to spend whatever additional income they receive. But in my opinion it is hard to believe that there are enough of those consumers to outweigh the effects of consumers who tend to smooth consumption and income over time.
So temporary tax cuts don't appear to have much impact. Permanent tax cuts that affect consumers' behavior, as well as the behavior of investors, entrepreneurs, etc., are much more capable of boosting economic growth.
Sunday, January 1, 2012
Wednesday, December 21, 2011
Ron Paul's Impossible Budget
Today Yahoo! News is carrying a story describing Ron Paul's budget proposal. Among other things, Paul intends to cut $1 trillion in government spending in his first year in office. Looking at a report on 2011 discretionary spending released by the CBO in October, Paul's $1 trillion figure apparently covers the entire four-year Presidential term. For the sake of argument, then, let us consider a $250 billion per year cut in government spending.
A $250 billion per year reduction in discretionary government spending would create economic havoc, particularly now when the economy remains weak.
From introductory macroeconomics, the total economic output of the country, Y, as measured by GDP, is
where C is consumption spending, G is government spending, I is investment, and NX is net exports. The government spending multiplier measures the amount Y increases for an increase in G. Traditional Keynesian economics purports that the spending multiplier is greater than one: as the government purchases more goods, workers who produce those goods earn more income which is then spent on consumption goods, and so on. Modern economic analysis suggests the spending multiplier is less than one for at least two reasons: to pay for the increased government spending, consumers anticipate future higher taxes and therefore save money to smooth consumption in the face of lower future after-tax income; and the increase in government borrowing to pay for the spending leads to an increase in interest rates, and hence lower investment. The fact that short-term interest rates are stuck at zero implies that the government spending multiplier is higher now than in more normal times. In most analyses, the spending multiplier has a symmetric effect, in that reducing G by $1 lowers GDP by $1 times the government spending multiplier. For the sake of argument, let's just assume a multiplier of one.
As of 2011Q3, the U.S. GDP was about $15.2 trillion. $250 billion represents 1.64% of U.S. GDP. Thus, Ron Paul's budget, assuming a government spending multiplier of unity, would reduce GDP by 1.6% than it otherwise would be in 2012.
Most economists are predicting a bit of a slowdown in 2012 compared to 2011Q4, with estimates for GDP growth typically in the 2%-2.5% range. With Ron Paul in charge, GDP would grow a paltry 0.4%-0.9% range.
I suspect the 1.6% hit to GDP estimate is, if anything, much too optimistic. Eliminating entire cabinet-level departments, while perhaps good in the long-run, would cause hundreds of thousands of layoffs, which would have a further impact on the overall economy. The hit to the DC metro area would be devastating, because not only would government workers be affected, so to would all the contractors that provide services to the government.
While shrinking the size of government and eliminating wasteful spending are noble goals that will increase U.S. economic performance in the long-run, those changes must be made gradually so they do not shock the economy and should be announced at least a few years in advance to give affected parties time to adjust. Ron Paul's idea of cutting $1 trillion in four years, given the current economic environment, would likely put the economy into a prolonged recession.
Please do not vote for Ron Paul. Simple analysis reveals his ideas are not feasible. And don't get me started on his ideas for interfering with the Fed's independence and returning to the gold standard...
A $250 billion per year reduction in discretionary government spending would create economic havoc, particularly now when the economy remains weak.
From introductory macroeconomics, the total economic output of the country, Y, as measured by GDP, is
Y = C + I + G + NX
where C is consumption spending, G is government spending, I is investment, and NX is net exports. The government spending multiplier measures the amount Y increases for an increase in G. Traditional Keynesian economics purports that the spending multiplier is greater than one: as the government purchases more goods, workers who produce those goods earn more income which is then spent on consumption goods, and so on. Modern economic analysis suggests the spending multiplier is less than one for at least two reasons: to pay for the increased government spending, consumers anticipate future higher taxes and therefore save money to smooth consumption in the face of lower future after-tax income; and the increase in government borrowing to pay for the spending leads to an increase in interest rates, and hence lower investment. The fact that short-term interest rates are stuck at zero implies that the government spending multiplier is higher now than in more normal times. In most analyses, the spending multiplier has a symmetric effect, in that reducing G by $1 lowers GDP by $1 times the government spending multiplier. For the sake of argument, let's just assume a multiplier of one.
As of 2011Q3, the U.S. GDP was about $15.2 trillion. $250 billion represents 1.64% of U.S. GDP. Thus, Ron Paul's budget, assuming a government spending multiplier of unity, would reduce GDP by 1.6% than it otherwise would be in 2012.
Most economists are predicting a bit of a slowdown in 2012 compared to 2011Q4, with estimates for GDP growth typically in the 2%-2.5% range. With Ron Paul in charge, GDP would grow a paltry 0.4%-0.9% range.
I suspect the 1.6% hit to GDP estimate is, if anything, much too optimistic. Eliminating entire cabinet-level departments, while perhaps good in the long-run, would cause hundreds of thousands of layoffs, which would have a further impact on the overall economy. The hit to the DC metro area would be devastating, because not only would government workers be affected, so to would all the contractors that provide services to the government.
While shrinking the size of government and eliminating wasteful spending are noble goals that will increase U.S. economic performance in the long-run, those changes must be made gradually so they do not shock the economy and should be announced at least a few years in advance to give affected parties time to adjust. Ron Paul's idea of cutting $1 trillion in four years, given the current economic environment, would likely put the economy into a prolonged recession.
Please do not vote for Ron Paul. Simple analysis reveals his ideas are not feasible. And don't get me started on his ideas for interfering with the Fed's independence and returning to the gold standard...
Monday, December 19, 2011
Say No To A Balanced Budget Amendment
Many of the Republican candidates, Tea Party leaders, and others on the right have come out in favor of a balanced budget amendment (BBA) to the Constitution. Michele Bachmann, for example, last month voted in favor of House Joint Resolution 2, calling for a BBA that requires total federal outlays in a fiscal year not to exceed federal revenues unless both the House and the Senate pass a resolution by a three-fifths margin to ignore that requirement.
The ability to override the amendment with a three-fifths majority removes much of its power, because when push comes to shove, most Representatives and Senators would vote to override the amendment rather than face potentially draconian spending cuts that could affect their own constituents.
More importantly, a balanced budget amendment is bad economic policy.
Comparing the federal government budget to a household's budget is misguided. A sovereign nation has the power to tax and to create money. Moreover, the U.S. is able to borrow money from foreign investors at historically low interest rates. Investors are willing to give the government money now in exchange for an implicit agreement by the government to tax its citizens in the future at a rate sufficient to repay the debt. On the other hand, if a household spends more than it takes in, it must borrow money, typically at high interest rates if it uses credit cards. The only way the household can pay off the debt is if it increases its earnings in the future, yet for most people wages grow only modestly over time. Therefore, there is a firm limit, often zero, to how much a household can borrow at any given time. Households cannot spend much more than they take in -- rational investors only extend credit to the extent that they are confident in being repaid. Governments have taxing authority; individuals do not.
Tax revenues flowing into the government's coffers are procyclical, meaning that they are higher when the economy is doing well and lower when the economy is doing poorly. During economic expansions, corporate profits and hence taxes are higher; investors record capital gains and hence pay capital gains taxes; and more people are employed for longer hours, so wage-based tax revenues are higher. During recessions, the opposite is true, and tax revenues are therefore lower.
Government spending is countercyclical, meaning that spending is higher when the economy is weak and lower when the economy is stronger. During a recession, more people become unemployed; and government spending, in the form of unemployment insurance payments, increases. More people become eligible for food assistance programs as the economy weakens, driving up those costs as well. To the extent that federal transfers help fund states' Medicaid programs, spending increases because more people are eligible for Medicaid payments. Whether unemployment benefits should extend more than six months, whether 99 weeks of benefits deter people from actively searching for work, how generous our food stamp program should be, etc., are all legitimate policy questions to ask. But the fact is that federal spending on those types of programs increases when the economy and labor market are weak.
So government revenue is procyclical while spending is countercyclical. Do you see a problem here? When the economy is at its weakest, government spending is higher and government revenue is lower. When the economy is booming, government spending is lower than it would otherwise be, while government revenue is higher.
Forcing the government to cut back spending when the economy is weak, as a BBA would require, is therefore a bad idea. Whether the Keynesian government spending multiplier is larger than one or smaller than one is a good, difficult question to answer that I may address later. But the vast majority of economists agree it is positive. The spending cuts that would be required by a BBA would cause the economy to be even weaker than it would otherwise be during a recession!
In short, with a BBA recessions would become more severe than they otherwise would be. They would force government spending to shrink at precisely the wrong time.
A balanced budget amendment makes for good campaign rhetoric but not good economic policy.
The ability to override the amendment with a three-fifths majority removes much of its power, because when push comes to shove, most Representatives and Senators would vote to override the amendment rather than face potentially draconian spending cuts that could affect their own constituents.
More importantly, a balanced budget amendment is bad economic policy.
Comparing the federal government budget to a household's budget is misguided. A sovereign nation has the power to tax and to create money. Moreover, the U.S. is able to borrow money from foreign investors at historically low interest rates. Investors are willing to give the government money now in exchange for an implicit agreement by the government to tax its citizens in the future at a rate sufficient to repay the debt. On the other hand, if a household spends more than it takes in, it must borrow money, typically at high interest rates if it uses credit cards. The only way the household can pay off the debt is if it increases its earnings in the future, yet for most people wages grow only modestly over time. Therefore, there is a firm limit, often zero, to how much a household can borrow at any given time. Households cannot spend much more than they take in -- rational investors only extend credit to the extent that they are confident in being repaid. Governments have taxing authority; individuals do not.
Tax revenues flowing into the government's coffers are procyclical, meaning that they are higher when the economy is doing well and lower when the economy is doing poorly. During economic expansions, corporate profits and hence taxes are higher; investors record capital gains and hence pay capital gains taxes; and more people are employed for longer hours, so wage-based tax revenues are higher. During recessions, the opposite is true, and tax revenues are therefore lower.
Government spending is countercyclical, meaning that spending is higher when the economy is weak and lower when the economy is stronger. During a recession, more people become unemployed; and government spending, in the form of unemployment insurance payments, increases. More people become eligible for food assistance programs as the economy weakens, driving up those costs as well. To the extent that federal transfers help fund states' Medicaid programs, spending increases because more people are eligible for Medicaid payments. Whether unemployment benefits should extend more than six months, whether 99 weeks of benefits deter people from actively searching for work, how generous our food stamp program should be, etc., are all legitimate policy questions to ask. But the fact is that federal spending on those types of programs increases when the economy and labor market are weak.
So government revenue is procyclical while spending is countercyclical. Do you see a problem here? When the economy is at its weakest, government spending is higher and government revenue is lower. When the economy is booming, government spending is lower than it would otherwise be, while government revenue is higher.
Forcing the government to cut back spending when the economy is weak, as a BBA would require, is therefore a bad idea. Whether the Keynesian government spending multiplier is larger than one or smaller than one is a good, difficult question to answer that I may address later. But the vast majority of economists agree it is positive. The spending cuts that would be required by a BBA would cause the economy to be even weaker than it would otherwise be during a recession!
In short, with a BBA recessions would become more severe than they otherwise would be. They would force government spending to shrink at precisely the wrong time.
A balanced budget amendment makes for good campaign rhetoric but not good economic policy.
Sunday, December 18, 2011
Judging The Candidates' Economics
The Republican candidates have been in full force preparing for the primary elections that will be starting soon. As an economist many of their policy proposals and statements have baffled me. President Obama is equally guilty of making economic statements that just are not true. Over the next several weeks I intend to comment on the candidates' economic philosophies and proposals.
To reduce unemployment and improve the nation's fiscal position, we absolutely need to get the economy growing at a faster clip. In my opinion that requires laying out a roadmap for future taxes and spending and addressing the structural deficits related to Social Security and Medicare. In upcoming posts I will be grading the candidates and President Obama on their ability to get this job done.
Stay tuned.
To reduce unemployment and improve the nation's fiscal position, we absolutely need to get the economy growing at a faster clip. In my opinion that requires laying out a roadmap for future taxes and spending and addressing the structural deficits related to Social Security and Medicare. In upcoming posts I will be grading the candidates and President Obama on their ability to get this job done.
Stay tuned.
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