Most people in the incoming Obama administration–and, indeed, most people– believe that the Keynesian model of the economy is basically correct. Developed from the theories of John Maynard Keynes, this model maintains that economies can veer away from full employment for a long time.
To combat high unemployment, Keynesians advocate having the government increase aggregate demand for goods and services. In the Keynesian model, the government can do this by either cutting taxes or increasing spending.
Interestingly, though, President-elect Obama’s candidate for chairman of the Council of Economic Advisers, Christina Romer, herself a Keynesian, has done research that undercuts the Keynesian view of good fiscal policy. Some of this research is in a March 2007 paper, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” co-authored with her husband, fellow University of California, Berkeley, economist David Romer.
In their article, they find that “tax increases are highly contractionary” and that tax cuts are highly expansionary. Otherwise-careful economists Greg Mankiw of Harvard and Lawrence Lindsey of the American Enterprise Institute have run with this result, as they should, but in doing so they have seriously misstated their findings.
Therefore, it’s worth looking at what the Romers did and didn’t find. Their bottom line is that “exogenous” tax cuts–that is, tax cuts not intended to offset the business cycle–have a large positive effect on gross domestic product. Specifically, a tax cut of 1% of GDP will raise GDP by about 3%.
The Romers’ research actually undercuts the Keynesian approach in a more fundamental way. They find that tax cuts to offset a recession are ineffective, but their reasoning would also apply to government spending increases to offset a recession. In other words, if she believes her own research, Christina Romer should be a strong critic of her new boss’s policies.
The Romers carefully sift through all federal tax cuts and tax increases from 1947 to 2005 to figure out, based on the discussion at the time, whether the changes in tax policy were motivated by a desire to offset the business cycle or by other goals. When they strip out the tax changes meant to offset the business cycle, they find that the other tax changes were highly effective. A tax decrease of 1% of GDP raised GDP by about 3%, and, symmetrically, a tax increase of 1% of GDP reduced GDP by about 3%.
Tax changes intended to offset the business cycle, though, aren’t so effective. The Romers write, “[C]ountercyclical fiscal policy is not achieving its intended purpose.” Why? “[I]t is difficult for fiscal policy to respond quickly to economic developments.” The two largest countercyclical tax changes between 1947 and 2005 were Lyndon Johnson’s 10% surcharge on income taxes, implemented to “cool off” the economy, and Gerald Ford’s 1975 tax rebate, implemented to boost the economy.
The Romers point out that the surcharge was first proposed in January 1967 but wasn’t passed until June 1968. And, although the 1975 tax rebate was passed within three months of being proposed, they note that it was not proposed until 14 months into the 1973-75 recession. They could have noted that the recession ended in March 1975, the same month the rebate was proposed and three months before it was passed.
Changes in government spending to offset the business cycle are also fiscal policy, and they have the same problem. We are well into the recession, we don’t know how long it will last and we won’t get an actual “stimulus” bill signed before February at the earliest. Even the pessimistic Federal Reserve is predicting a recovery beginning in the second half of 2009. Although Harvard economist Martin Feldstein has become an advocate of increased military spending to get us out of the recession, he was more on point when he was my boss at the Council of Economic Advisers under President Reagan and testified against a “jobs” bill before a congressional committee. Feldstein told them that one of the best indicators that we have come out of a recession is that Congress proposes a jobs bill.
One big problem with the Romers’ research, which they acknowledge, is that in their model one tax cut of a given magnitude is identical to another tax cut of the same magnitude. It doesn’t matter, in their model, whether the tax cut comes from a tax credit or from a cut in marginal tax rates. But, of course, it does matter.
Take the proposed Obama tax cut. The largest part of the proposed tax cut is a tax credit. This is perverse. Putting aside the fact that this tax credit is really a spending increase, because it will go even to people who pay no federal income tax, there’s another objection. Even economists who don’t think of themselves as supply-siders will admit that the higher a tax rate is, the more it reduces incentives–to work, save and invest.
In fact, a theorem in economics shows that the distortion from taxes–what economists call the dead-weight loss–is proportional to the square of the tax rate: Double the tax rate and you quadruple the dead-weight loss from taxes. But an increase in a tax credit does not cut any tax rate and, therefore, reverses no disincentive effect.
The best thing the federal government could do now is avoid the phony Obama tax cut and not increase spending at all. It’s time for the Senate Republicans to step up.
This article first appeared in Forbes magazine.