The Implications of a Textbook Analysis of Macro Stabilization via Discretionary Fiscal Policy

From Reuters:

If Bush and Congress are to act at all, they will have to move quickly to have any impact, says Alan Auerbach, an economics professor at the University of California, Berkeley, who has done research on the effects of fiscal stimulus.

“Timing is extremely important,” he says. “Recessions typically last less than a year, so unless you can be pretty quick, it’s not worth doing.”

This quote highlights the key aspects of the textbook analysis of discretionary fiscal policy. With the talk from both sides of the ideological aisle promoting discretionary fiscal policy (see Reuters, NYT, Economist’s View, Krugman) I thought it useful to refer to the feasibility and advisability of such approaches.

In short, the conventional wisdom asserts that the inside lag — the time between recognition of a problem and action — for monetary policy is short and the outside lag — the time between action and the impact of the policy — is long, while the reverse is true for discretionary monetary fiscal policy. The argument follows from the fact that discretionary fiscal policy requires legislative and executive branch concurrence and action, which might be prolonged in nature. In contrast, spending, and associated multiplier effects of spending, can usually be effected fairly rapidly. (Tax policy via rebates, and changes in the statutory tax rates, can be slower, unless one has a pure rat-ex view of the world). These characterizations regarding outside lags are reflected in the estimated magnitudes of fiscal and monetary multipliers in conventional macroeconometric models (e.g., Interlink, as discussed here).

This is why I think it makes a lot more sense to focus on re-calibrating automatic fiscal stabilizers already built into the system, rather than chunky, discretionary, changes to spending or taxes. Of course, this is not a unique view. For an enumeration of criteria (similar to those laid out by Elmendorf and Furman’s primer), and a comprehensive set of proposals, see the Center for Budget and Policy Priority‘s analysis (by Chad Stone and Kris Cox):

Evaluating Specific Stimulus Proposals

The following measures rank highly according to the criteria for good stimulus:

    • Strengthened unemployment insurance. As discussed, temporary increases in unemployment insurance benefits are a particularly effective form of economic stimulus. The benefits go to workers who have lost their jobs and suffered a temporary decline in their income relative to their normal expenditures. As a result, the added income is likely to be spent quickly. Analysis by economists Alan Auerbach and Daniel Feenberg concluded that per dollar of cost, the automatic stabilizer effects of the increase in unemployment insurance payments that occurs in a downturn are at least eight times as large as the effects of the reduction in tax collections that occurs.[25]

      A fiscal stimulus package accordingly should include a temporary measure to provide additional weeks of federally funded UI benefits for workers who exhaust their regular UI benefits before they can find work. Additional weeks of UI benefits have been provided in every recession in recent decades, and the case for them will be especially strong if a new recession sets in. The percentage of unemployed workers who have remained without a job for more than 26 weeks (the normal duration for regular unemployment benefits) and continue to search for work — a group sometimes referred to as the “long-term unemployed” — has remained stubbornly high and is considerably higher now than it was at the start of the last recession (17.5 percent in December 2007, compared with 11.1 percent in March 2001). In addition, UI benefit levels are quite low in many states, so a temporary increase in the weekly benefit amounts also would warrant consideration.

      In addition, Congress should take long-overdue action to address weaknesses in the UI program itself. UI coverage has eroded in recent decades, and only 37 percent of unemployed workers now receive unemployment benefits. The design of the UI program dates in substantial part from the 1930s; many low-income and part-time workers who are laid off do not qualify for UI benefits because of outmoded rules that do not reflect today’s workplace. (This is a particular problem for low-income women who lose their jobs.) In the mid-1990s, the congressionally chartered, bipartisan Advisory Commission on Unemployment Insurance recommended measures to remedy this problem, but Congress never acted on them.

      In October 2007, the House finally passed UI reform provisions[26] that reflect several key commission recommendations and would provide states with incentives to modernize their UI systems so more female, low-income, and part-time workers who lose their jobs through no fault of their own can qualify for benefits. (The measure is fully paid for through a renewal of the federal unemployment insurance surtax, a step that President Bush called for in his last budget.) If the Senate were to act expeditiously on these provisions or similar legislation in January, these reforms would be in place to strengthen UI’s automatic stabilizer role in the next recession, whenever that occurs. But if rapid Senate action on that legislation is not forthcoming, this problem could be addressed on a temporary basis as part of a stimulus package.

  • State fiscal relief. As noted, temporary federal fiscal relief reduces the need for states to enact tax increases and spending cuts in a recession. A temporary increase in the federal Medicaid matching rate (to help states avert cutting Medicaid coverage) is one effective component of such relief, along with the provision of general fiscal relief to states. In addition, in light of the growing pressures on local governments from declining property tax revenues, fiscal relief should be designed to encourage states to temporarily increase assistance to local governments, rather than to cut back such aid, as states often do in economic downturns to help balance their budgets. In short, as in 2003, temporary fiscal relief to states could include a combination of general aid and Medicaid-specific relief.
  • Uniform tax refunds. Tax cuts can provide effective economic stimulus, if — but only if — taxpayers spend quickly the resulting increase in their disposable incomes. This argues against proposals for across-the-board reductions in income tax rates or other tax breaks that would provide the largest benefits to higher-income taxpayers, who are likely to save rather than spend a substantial portion of any tax cut they receive. (At a recent Brookings Institution forum on stimulus, Martin Feldstein concurred that a temporary tax rate cut would not be effective as stimulus.) This also argues against tax cuts in capital gains or dividends, which would go even more disproportionately to those high up on the income scale.

    In contrast, a tax rebate of a uniform amount for all tax filers would put money into people’s hands quickly and direct a large proportion of the total to people likely to spend it. The rebate could go to all taxpayers who filed a federal income tax return the previous year, or to everyone who worked and paid FICA taxes (whether or not they filed an income tax return). The amount, presumably several hundred dollars, would be the same for all taxpayers and would not be tied to how much tax they paid.

  • Temporary increase in food stamp payments. Many low-income consumers are not tax filers and do not receive unemployment insurance. Hence, they would not qualify for a tax rebate or for extended UI benefits. Yet they experience particular hardship when the job market is weak and when states cut back on services. A temporary increase in food stamp benefit levels would provide helpful support to poor households and would almost certainly be spent very quickly. Dollar-for-dollar, this is one of the most effective forms of stimulus available.

One reason to favor temporary modifications to automatic stabilizers, as opposed to permanent changes in the tax code, is that the current full-employment budget balance is probably around negative one percentage point of GDP, and we are facing an expanding deficit in the future, given the press of demographics and medical costs (see Orszag’s speech [pdf]).

In addition, one has to beware of attempts to overturn the original intent of the tax cut legislation of 2001 and 2003, which established sunset provisions. Extending these provisions will not necessarily stabilize the economy, especially given the implications for the resulting debt trends (see this post for some alarming pictures).

Departing from textbook macro, I might note that to the extent that consumers are not risk neutral (and their behvior not characterized by certainty equivalence), then consumption depends not only on current and expected future disposable income, but negatively on income (and cost) uncertainty. To the extent that the measures above reduce uncertainty, they will tend to maintain consumption in ways that are not typically accounted for (astute readers will recognize this as an argument based upon buffer stock models of saving and hence consumption, as described here).

I also find some irony that the Administration that loudly professed fiscal restraint as a reason to kill off SCHIP expansion is now willing to consider all sorts of budget deficit increasing provisions (business incentives, extending tax reductions that make the tax code more regressive) that will enrich those at higher income levels. But that is a tale of ideology, rather than economics.

[Late addition: 1/15, 5:30pm]

CBO has just released Options for Responding to Short-Term EconomicWeakness [pdf].

Technorati Tags: recession, fiscal policy, monetary policy, automatic stabilizers, , .

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7 thoughts on “The Implications of a Textbook Analysis of Macro Stabilization via Discretionary Fiscal Policy

  1. Gegner

    You point to an interesting conundrum, if economic stimulus is directed towards those inclined to spend it rapidly, most folks at the lower end of the economic distribution would use a ‘windfall’ to paydown their debt…which does nothing to ‘stimulate’ the economy as paying down debt merely puts the money towards past purchases.
    Then we look toward the small segment of society that has no debt…who are therefore more likely to ‘save/bank’ their windfall, something that also fails to ‘stimulate’ the economy.
    Which points us toward a real conundrum, the current administration has spent more in the past seven years than every administration before it combined (The national debt has more than doubled.)
    Where is the ‘economic stimulus’ of all of that spending? What does our society have to show for this huge sum of cash?
    Nada!
    Some credit WWII for pulling this nation out of the Great Depression…well, the current administration has spent a half a trillion dollars on the ‘War on Terra’ and our economy is tanking…so where is that money going?
    Now we are expected to believe that throwing an additional ‘hundred billion’ (one fifth of what they’ve sunk into the Middle East’) or a sliver of the original Bush tax cuts is going to make a difference?
    It’s difficult to comprehend how more tax cuts or Federal spending is going to accomplish anything given how this administration has already squandered 5 trillion dollars and we have absolutely zero to show for it!

  2. kharris

    Automatic stabilizers are the obvious answer for two reasons. One is the shortened inside lag that you point out. The other is that automatic stabilizers reduces the legitimate incentive for Congress to manipulate tax and spending for other than long-term purposes. Constituencies build to make tax and spending stimulus permanent as soon as it’s put in place. The Bush tax cuts are a great example. The howls of outrage at the notion that a tax cut sold as temporary in order to reduce its long-term budget impact should actually be allowed to lapse is all the evidence one should need of the corrupting influence of discressionary fiscal stimulus packages.
    That is, quite probably, one reason that we won’t see an increase in the use of automatic stabilizers. The argument will be couched in terms of “big government” and “bureaucrats” and the like, but it is really all about lost political opportunity. Privatization, now that we have seen how it works, has similar problems. A bunch of public sector professionals may do a better job, but they have far less motive to make political contributions.

  3. Israel Ramirez

    I thought unemployment insurance tends to lengthen unemployment by making it easier for workers to wait until they get a more desirable job instead of taking the first job they find. Wouldn’t that effect enhance a recession?

  4. jg

    Aw, Israel, you are too logical.
    Pay folks not to work and, guess what, they do not work.
    No wonder we have a terrible savings rate: we rely upon Leviathan (government) to rescue us, instead of self and family.
    Scrap unemployment insurance contributions and let folks and family fend for self.
    The sum is niggardly, anyway; won’t even cover rent and utilities here in SoCal.

  5. gdada

    Israel wrote:
    I thought unemployment insurance tends to lengthen unemployment by making it easier for workers to wait until they get a more desirable job instead of taking the first job they find. Wouldn’t that effect enhance a recession?
    It’s a tradeoff.
    On the margin, there is no doubt that some workers would prefer to remain unemployed and receive a steady check from the government than actually work. That is the efficiency cost of the program (aside from the opportunity costs of spending the money on this extension). Without a doubt, when unemployment benefits are sufficiently high, they can create substantial disincentives to work.
    That said, there is a substantial fraction that WOULD work if work was available*** — those individuals’ decisions will be unaffected by the extension of the insurance.
    The benefits of the program are twofold — from a macro perspective, it smooths out the path of the economy by making a recession less extreme. And from a welfare perspective, it helps those who would be hardest hit by a recession (the unemployed).
    Economists supporting such a program generally agree that the benefits I outlined would outweigh the efficiency and opportunity costs. That is partially an empirical/positive question and partially a normative one.

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