Saturday, January 30, 2010

Orszag and Stiglitz: Tax cuts are not automatically the best stimulus

The Center on Budget and Policy Priorities posted a 2001 article by Peter Orszag, currently at the Office of Management and the Budget, and Joseph Stiglitz, a Nobel prize-winning economist, who argue that tax cuts are not always the best thing to do in the recession. This is relevant because Scott Brown, who won the Senatorial election in Massachusetts, correctly pointed out that John F. Kennedy did indeed propose cutting taxes during the 1960 recession - albeit his tax cuts took too much time to have an impact and they mainly hit after the recession, and Kennedy seems to have wanted a spending program as well.

Orszag and Stiglitz argue in response to a 2001 Bush administration official who suggested tax cuts in response to the 2001 recession:

The principal reason that Mr. Hubbard's arguments are misguided — and the main reason the Administration's package would be relatively ineffective as a stimulus measure — is that they largely ignore the central feature of a recession: lack of demand. In a recession, the primary problem is that the nation's firms face a reduction in demand for their products — not that they lack available workers, equipment, or anything else needed to produce goods and services. Indiscriminately injecting cash into such firms through tax breaks, without linking the tax breaks to new business activity, would do little if anything to address the underlying difficulty.

Firms that are faced with reduced demand for their products lay off workers, regardless of how much cash they have. The managers of firms have a fiduciary responsibility to maximize their profits, and in the face of reduced demand for their product, firms therefore typically reduce costs by cutting back on production, which triggers layoffs. As the number of unemployed workers increases, a downward economic spiral can occur. Households with unemployed workers, facing a sharp decline in their incomes, cut back on spending and further reduce the demand for products. That, in turn, leads to additional layoffs. This harmful cycle, by which an economic slowdown can build into a more serious recession, can be arrested or broken by boosting demand for the goods and services that American companies produce. Only when a company faces renewed demand for its products will it end the process of shedding workers and begin to create new jobs. As a result, the primary objective of a stimulus package should be to spur spending on these products.

In other words, when you cut taxes to businesses unconditionally, they are more likely to save the money in a recession than to spend it. Business tax cuts should be tied to investment or hiring. When you cut taxes to higher-income households, they are also more likely to save the additional money than to spend it. These are supply-side interventions. Supply-side economics (hat tip to Wikipedia holds that economic well-being should be maximized by removing or minimizing barriers to producing goods and services - barriers such as taxes.

What is effective is spending measures that are immediate:

An effective stimulus package consequently should expand the aggregate demand for goods and services in a timely way. Mr. Hubbard notwithstanding, there is little question that increases in government expenditures can be quite effective in boosting aggregate demand and thereby stimulating the economy in the short run.

Temporary expansions in unemployment insurance, for example, would spur increased consumer spending. Households in which a worker is laid off experience a significant decline in income. They thus are likely to spend a high percentage of any additional income they receive while out of work. The extra spending on unemployment benefits that a temporary expansion of unemployment benefits provides thus has a direct economic benefit — it keeps more workers employed at firms that produce the products the unemployed workers purchase with their additional cash. Temporary expansions in unemployment insurance consequently are a "win-win" proposition: They are quite effective in helping more people keep their jobs during an economic downturn, and they also assist those who are unfortunate enough to have lost their jobs.

Increased funds for food stamps and Medicaid also fall into this category. These have been the fastest-acting parts of the most recent stimulus bill.

Conservatives will tell you that increased government debt crowds out private spending - in other words, one dollar of government spending which is financed through taxation prevents private industry from spending that dollar. The private sector might see a higher rate of return on that dollar than the government. This view has some validity when the economy's resources are being fully utilized, but not in a recession:

The notion that a dollar spent by the government "crowds out" one dollar of spending by private businesses is correct only when the economy's resources are fully utilized; in that case, additional demand on those resources by the government necessarily reduces the demands that can be placed on them by the private sector. But when the economy's resources — our workers and plants and equipment — are not fully utilized, government spending does not displace private-sector resources on a dollar-for-dollar basis. Indeed, during an economic downturn, government spending can "crowd in" additional private-sector activity by spurring overall demand and thereby making it more likely that firms will be willing to make new investments. Mr. Hubbard's argument about government spending fully crowding out business spending thus is puzzling; it would be valid only if the economy were fully utilizing its resources, which is clearly not the case now.

The latest data [Editor: remember, this is 2001, but the story is similar today], for example, show that the capacity utilization rate — the proportion of plant and equipment capacity being used in production — fell to 74.8 percent in October, its lowest level since 1983. Furthermore, any implication that the economy is fully utilizing its resources would be inconsistent with another statement Mr. Hubbard makes — namely, that "the economy needs help now."

In other words, to counter a recession, you have to get demand for goods and services back up - and the federal government is the last entity left standing with the power to buy stuff in a recession.

Not long ago, I believe that Rowan Williams, Archbishop of Canterbury, was wondering why the government was spending money to stimulate the economy so that people could buy more useless junk in a recession. Hadn't we learned enough from our materialistic past, he wondered (I'm paraphrasing). That is indeed a critically important question that the church needs to help our society explore. However, when the rich sneeze, the poor catch a cold - paraphrased from when America sneezes, African-Americans get a cold. Recessions always affect vulnerable groups more severely than everyone else, and we need to get out of the recession.

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