Tax Cuts Might Be Better For Growth Than Spending

See Why the Spending Stimulus Failed: New economic research shows why lower tax rates do far more to spur growth by Michael Boskin, from the WSJ, 12-1-10. He is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He chaired the Council of Economic Advisers under President George H.W. Bush. Key excerpts:

"In a dynamic economy, many parts are moving simultaneously and it is difficult to disentangle cause and effect. Taxes may be cut and spending increased at the same time and those may coincide with natural business cycle dynamics and monetary policy shifts.

Using powerful statistical methods to separate these effects in U.S. data, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago conclude that the small initial spending multiplier turns negative by the start of the second year. In a new cross-national time series study, Ethan Ilzetzki of the London School of Economics and Enrique Mendoza and Carlos Vegh of the University of Maryland conclude that in open economies with flexible exchange rates, "a fiscal expansion leads to no significant output gains."

My colleagues John Cogan and John Taylor, with Volker Wieland and Tobias Cwik, demonstrate that government purchases have a GDP impact far smaller in New Keynesian than Old Keynesian models and quickly crowd out the private sector. They estimate the effect of the February 2009 stimulus at a puny 0.2% of GDP by now.

By contrast, the last two major tax cuts—President Reagan's in 1981-83 and President George W. Bush's in 2003—boosted growth. They lowered marginal tax rates and were longer lasting, both keys to success. In a survey of fiscal policy changes in the OECD over the past four decades, Harvard's Albert Alesina and Silvia Ardagna conclude that tax cuts have been far more likely to increase growth than has more spending.

Former Obama adviser Christina Romer and David Romer of the University of California, Berkeley, estimate a tax-cut multiplier of 3.0, meaning $1 of lower taxes raises short-run output by $3. Messrs. Mountford and Uhlig show that substantial tax cuts had a far larger impact on output and employment than spending increases, with a multiplier up to 5.0.

Conversely, a tax increase is very damaging. Mr. Barro and Bain Capital's Charles Redlick estimate large negative effects of increased marginal tax rates on GDP. The best stimulus now is to stop the impending tax hikes. Mr. Alesina and Ms. Ardagna also conclude that spending cuts are more likely to reduce deficits and debt-to-GDP ratios, and less likely to cause recessions, than are tax increases.

These empirical studies leave many leading economists dubious about the ability of government spending to boost the economy in the short run. Worse, the large long-term costs of debt-financed spending are ignored in most studies of short-run fiscal stimulus and even more so in the political debate.

Mr. Uhlig estimates that a dollar of deficit-financed spending costs the economy a present value of $3.40. The spending would have to be remarkably productive, both in its own right and in generating jobs and income, for it to be worth even half that future cost. The University of Maryland's Carmen Reinhart, Harvard's Ken Rogoff and the International Monetary Fund all conclude that the high government debt-to-GDP ratios we are approaching damage growth severely."