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General principles for a counter-cyclical fiscal stimulus

Here are some basic guidelines to follow in drafting a fiscal stimulus package:

Fiscal policy

The federal government’s decisions about the amount of money it spends and collects in taxes to achieve a full employment and non-inflationary economy.

1. Nothing should be retroactive; rather, it should provide incentives or reduce disincentives.

2. Policy changes should have maximum effect in the short-run while reducing the long-run impact.

3. If the long-run outlook is strong, the fiscal stimulus should act to counter the economic shock that caused the slowdown or recession.

When deciding on a fiscal stimulus, there are several questions that need to be answered.

Tax cuts: Businesses or Individuals?

Any tax cuts for businesses ought to be aimed at stimulating investment. Retroactive tax reductions are NOT the way to do this. A tax credit or accelerated depreciation would be a better policy in the sense that the “bang for the buck” is much greater than a lump sum transfer of money to the companies.

If there are business that are viable in the long-run but are in danger of going out of business a helping hand would seem to make sense. The help given to the airline industry would be an example (however, it’s not clear that all of the companies are economically viable given their financial situation prior to 9.11). Personally, I think that the financial help could have been better structured as an incentive to get people to fly – perhaps as a subsidy to the company for each passenger-mile flown. This would have reduced the ticket prices even further and gotten more people back in the air.

Tax cuts aimed at individuals should be structured in a similar way as well so as to reduce the work disincentive effect of taxation. A rate reduction might therefore be preferable to a rebate. However, it is unlikely to make much of a difference which method is chosen – if the downturn is due to a reduction in consumer spending, the problem is a reduction in demand for workers, not a problem of decreased labor supply.

In addition, since recessions impact different people in different ways, simple fairness would dictate that policy should be focused more on those affected by the recession. Extension of unemployment benefits seems like a sensible way to address this problem.

Prior to 9.11, the cause of the slowdown seemed to be a lack of business investment, so a policy to boost investment would have been warranted by principle #3 above. However, post 9.11, the slowdown is more a result of a decline in consumer activity, so perhaps spurring the consumer would make more sense now.

Tax cuts: Temporary or Permanent?

Conventional economic analysis suggests that a permanent change in income tax policy should have a larger impact on spending behavior than would a temporary change. The reason is that a temporary tax break will likely be saved in anticipation of a higher tax burden in the future.

However, to the extent that people do spend some of the tax cut, a temporary cut would still have an effect. It might make sense to target the policy towards those that are likely to be influenced by it. In particular, a tax cut for those most in need would be spent to a greater amount than a tax cut to those who would be more likely to save the money.

In addition, if a slowdown or recession is thought to be temporary, it makes sense that any policy that reacts to it ought to be temporary as well (provided of course that a temporary policy would have some effect).

The temporary policy would also minimize the chance that the timing of the policy would miss the point at which it was needed.

With regards to a policy to encourage investment, a temporary tax incentive can have a larger impact on investment than a permanent tax incentive. This is because firms would want to shift investment to the period in which the tax treatment of investment is more favorable. In addition, the temporary tax change would be cheaper in the long run.

Spending or taxes?

This is a tough one. In principle, a well-designed tax stimulus would have similar effects on the short-run macroeconomy as a well-designed spending increase. Both policies would likely have a similar effect on the budget as well.

There is a difference in that tax cuts would increase the overall efficiency of the economy in addition to providing a macroeconomic stimulus. This would tend to cause us to lean towards a tax reduction.

However, if there are spending needs to be met, it would make sense to incorporate them into a stimulus package. For example, additional spending on airport security and defense is probably necessary – and this additional spending also serves to provide a boost to the economy at the same time.

For more:

Recession 101

Peter R. Orszag, Gene B. Sperling have argued that “any tax cut should be temporary, have a significant stimulative bang for the buck, and avoid long-term damage to the nation’s fiscal position.”

Unemployment Insurance and Fiscal Stimulus

Stimulating the Economy Through Tax Policy: Principles and Applications1

Tax Stimulus Options in the Aftermath of the Terrorist Attack

by William Gale, Peter Orszag, and Gene Sperling

Fiscal Policy:
Its Macroeconomic Perspective

by James Tobin

For a micro perspective see: Tax Cuts Or Spending-Does It Make a Difference?

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Filed under: Economics, Economy

U.S. Fiscal Policy Authority

Has its time come?

Stalemate

With a recession looking increasingly likely (as of 11.16.2001), the US Congress is
trying to find a solution to the problem of how to
stimulate the economy. Predictably, Republicans and Democrats have different views on how best to do this – the Republicans favor primarily tax cuts to corporations and upper income households (via an acceleration of the previously enacted tax reductions and a capital gains tax cut), while Democrats would prefer to either increase spending (primarily by extending unemployment benefits) and to rebate taxes to lower income households.

While this fighting happens in Washington, the economy does not receive a needed boost. This extensive “inside lag” – that is, the time it takes for policymakers to enact policy to fight recessions – is why most economists think the Fed is a more effective recession fighter.

In fact, the current political process tends to prevent congress from being effective counter-cyclical policymakers for several reasons.

1. Long delays in enacting policy

2. Political decisions adversely affect the composition of counter-cyclical fiscal policy

3. Inability to react to booms and to fight inflation

4. Tendency for policy to become permanent (policy inertia)

In addition to the delays, politicians tend to try to throw in their pet projects under the guise of an economic stimulus, regardless of their macroeconomic merit. Also, when was the last time the government reversed its tax cuts/spending increases once the recession was over? “Temporary” policies to fight a temporary problem have a long history of becoming permanent policies.

Fiscal Policy Authority (FPA)

One solution to this problem would be to give the job of macroeconomic policymaking to a quasi-independent organization along the lines of the Federal Reserve System. Such an Authority would be given some leeway to alter spending and/or taxes in order to pursue macroeconomic stabilization.

The FPA, for example, could be allowed to increase (or decrease) the duration of unemployment benefits. The FPA could perhaps be allowed to make adjustments to other policies such as investment tax credits, depreciation schedules, or even marginal income tax rates.

If the FPA were structured in a similar way to the Fed – managed by relatively independent long-term appointees, and given a clear mandate and policy tools – the FPA could react quickly to a changing economic environment. In addition, they would be free of the partisan and interest group politics that so often gets in the way of effective policymaking. Their independence would also add an additional tool in the fight against inflation.

Such an administration would not have exclusive control over policy, but it would allow congress and the president to focus on the long-run health of the federal government and the economy.

Would such a major overhaul be possible? Why would congress and the president give up control to an independent body? There is a precedent in the 1913 act of congress that created the Fed. However, it would certainly be an uphill battle to get an FPA authorized.

Perhaps the current fight will leave enough scars that the two parties would be willing to put the task of macroeconomic stabilization in someone else’s hands.

Filed under: Economics

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