Paul L. Caron

Sunday, December 13, 2009

Mankiw: Tax Cuts Work 2x Better Than Government Spending to Cure Recession

New York Times op-ed, Tax Cuts Might Accomplish What Spending Hasn’t, by N. Gregory Mankiw (Harvard University, Department of Economics):

When devising its fiscal package, the Obama administration relied on conventional economic models based in part on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy. The report in January put numbers to this conclusion. It says that an extra dollar of government spending raises GDP by $1.57, while a dollar of tax cuts raises GDP by only 99 cents. The implication is that if we are going to increase the budget deficit to promote growth and jobs, it is better to spend more than tax less.

But various recent studies suggest that conventional wisdom is backward.

One piece of evidence comes from Christina D. Romer, the chairwoman of the president’s Council of Economic Advisers. In work with her husband, David H. Romer, written at the University of California, Berkeley, just months before she took her current job, Ms. Romer found that tax policy has a powerful influence on economic activity. According to the Romers, each dollar of tax cuts has historically raised G.D.P. by about $3 — three times the figure used in the administration report. That is also far greater than most estimates of the effects of government spending.

Other recent work supports the Romers’ findings. In a December 2008 working paper, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago apply state-of-the-art statistical tools to United States data to compare the effects of deficit-financed spending, deficit-financed tax cuts and tax-financed spending. They report that “deficit-financed tax cuts work best among these three scenarios to improve G.D.P.”

My Harvard colleagues Alberto Alesina and Silvia Ardagna have recently conducted a comprehensive analysis of the issue. In an October study, they looked at large changes in fiscal policy in 21 nations in the Organization for Economic Cooperation and Development. They identified 91 episodes since 1970 in which policy moved to stimulate the economy. They then compared the policy interventions that succeeded — that is, those that were actually followed by robust growth — with those that failed.

The results are striking. Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending. ...

These studies point toward tax policy as the best fiscal tool to combat recession, particularly tax changes that influence incentives to invest, like an investment tax credit.

For a contrary view, see Citizens for Tax Justice, President Obama's Jobs Proposals.

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Yeah, but with tax cuts it's harder to funnel the money to your political supporters like unions, government employees and democratic polling firms. The stimulus was 20 percent stimulus and 80 percent democratic christmas tree.

Posted by: Loyola | Dec 14, 2009 12:06:57 AM

Successful stimulus relies almost entirely on cuts in business and income taxes.

Y'all can say this until you are all blue in your faces. Team Obama and their comrades-in-arms are likely to only reply with their fingers in their ears yelling, "LA LA LA LA LAAAAA, I"M NOT LISTENING TO YOU!!!".

Posted by: Flash Hole | Dec 14, 2009 12:15:28 AM

Tax cuts work better than graft laden public spending. And in other news....water is wet!

Posted by: mike | Dec 14, 2009 4:17:41 AM

Add to the historical stimulative inefficacy of government spending a towering overhang of potential government healthcare expansion, CO2 regulation and redistributive taxation. In what universe is it reasonable to expect meaningful resumption of small business hiring with such looming uncertainty regarding future profitability?

Posted by: Win | Dec 14, 2009 5:19:01 AM

The theory behind "government stimulus" is crap and always will be. Any business owner knows it, whether he can prove it to an economics professor or not.

Posted by: Chester White | Dec 14, 2009 6:11:40 AM

I've always looked at that calculation skeptically. How does a tax cut "cost" GDP and government spending not? Common sense tells me that there are two routes for the money to flow, and one has a significant amount of of what I call "friction".

Here's the scenario: the government takes $2000 from you. It goes to the treasury, and then feeds the budget for ,say, the "stimulus" office of XY department, who then disburses the money back to you IAW law and regulation, provided you fill out the forms and use it as they tell you. Barring outright graft, it still costs money to move that money in that circle; in salaries, office supplies, utilities costs, time, etc. In the end, that $2000 that went in is now certainly less in order to cover those costs. That's "friction". And all of that takes money out of GDP.

A tax cut of $2000, on the other hand, has no friction, as it never left your hands.

So, Keynesians, tell me again how governemnt spending stimulates more than tax cuts?

Posted by: Jeff Weimer | Dec 14, 2009 6:41:01 AM

Tax cuts worked so well for Bush. Thank goodness his cuts saved our economy!

Posted by: Denver | Dec 14, 2009 6:51:00 AM

Obama's response to shunning tax cuts in 2009: "We won."
Taxpayer reply in 2010 and 2012: "WE WON, YOU LOST!"

Posted by: Mad_as_H | Dec 14, 2009 7:06:46 AM

Yes, but the Reps of 2002-2006 who, as majority mostly supporters of the successful Bush Tax Cuts, failed time and time again to take credit for private (=peaceful) activity to get the US out of the bubble pop recession.

Posted by: Tom Grey | Dec 14, 2009 10:40:59 AM

@ Denver:

Thank you for your succinct analysis! You have clearly isolated correlative and causative variables and can now draw the only remaining conclusion: tax cuts are bad mmmmmm'kay.

Tax cuts are bad because the Bush years show how tax cuts are bad. How do we know they're bad - duh, because of the Bush years. Bush years + tax cuts = bad; therefore, tax cuts are bad. I believe I have no achieved the level of circularity and simplistic analysis of which Denver would strongly approve.

Posted by: john | Dec 14, 2009 11:51:53 AM

Tax cuts for the poor and middle class -- great idea. Tax cuts for the ultra rich -- the best road to neo-feudalism.

At some point, there has to be a means of equalizing incomes or we become a society of kings, nobles, knights and serfs once again. Debt serfdom is already rampant.

I am a personal injury lawyer, (32 years) not a tax lawyer. Sometimes you tax lawyers just know not what you advocate. Maybe you are just too far removed from the madding crowd.

If you want the equivalent of the French Revolution to come to 21st century America, keep up the clarion call to refuse to tax the rich. (Let's be frank, that's what every call to lower taxation is really about).

Next thing I expect to hear from the professor is to let us all eat cake. We know from history what happened to the last person to suggest that.

Posted by: davidgmills | Dec 14, 2009 1:30:17 PM

Right on, john.

I'm so sick of all this heartache over raising taxes on the rich, as if having to fork over a small portion of their fair share of taxes will reduce their standard of living. when balanced against the 95% of the rest of us who would largely be satisfied with being able to survive with a roof over our heads.
The class war has been waged between the Patricians and the Mob for thousands of years and will never stop, especially when the Elite Harvard types can still write this garbage with a straight face.

Posted by: GREG | Dec 14, 2009 3:48:32 PM

Keynesians have been debunked time and time again throughout history. Just ask anyone from the U.S.S.R. Ludwig Von Mises however makes a lot of sense.

Posted by: Rampaging Manatee | Dec 15, 2009 12:03:17 AM

The current "stimulus" does have tax cuts for low income households, but that will hardy simulate job creation.

Posted by: Neo | Dec 18, 2009 9:49:32 AM