Both political parties are determined to enact an economic stimulus package, and it is not difficult to understand why. In theory, the government can respond to an economic downturn through monetary policy – lowering interest rates – or through a policy of fiscal stimulation.
But interest rates cannot be lowered from zero, and the Federal Reserve Board has already dropped the target value of federal funds to approximately that rate. Hence, the consensus in favor of some form of fiscal stimulus.
One might argue that a fiscal stimulation policy already exists. According to the Congressional Budget Office (CBO), even without any new stimulus package the federal budget deficit will reach $1.2 trillion this year. That amounts to 8.3 percent of the Gross Domestic Product (GDP). The previous post-World War II record was 6 percent in 1983.
As Robert Levy of the American Enterprise Institute has observed, this sort of gap between government spending and taxes was just what John Maynard Keynes prescribed to stimulate slumping economies. But the federal deficit can always be increased. Thus, unlike monetary policy, fiscal policy has not exhausted itself as a potential response to our current difficulties.
In short, both parties are committed to “doing something,” and see fiscal policy as the only game still in town. The debate is over what type of fiscal policy to emphasize. Democrats favor government spending; Republicans favor tax cuts.
The Republicans have the better case. To be sure, textbook economics teaches that spending increases stimulate the economy more than tax cuts. A dollar spent is a dollar spent. A dollar in tax cuts might be spent or saved.
However, the empirical evidence casts doubt on this conventional Keynsian wisdom. One study, by economist Valerie Ramey, estimated that, historically, each $1 of spending by the U.S. government increases the GDP by only $1.40.
Meanwhile, according to a study by economists Christine Romer and David Romer, a dollar of tax cuts raises G.D.P. by $3. Christine Romer, by the way, heads President Obama’s Council of Economic Advisors.
There is also reason to fear that the increased government spending contemplated by the Democrats this time around will produce less bang for the buck than the historical average. As Robert Samuelson puts it, large portions of the House package resemble “a giant political slush fund.” The package contains sizeable expenditures ($15.6 billion in Pell grants for student loans, for example) that have very little potential to increase the number of jobs.
But even a spending package that focused laser-like on infrastructure and other job intensive programs would be a severely flawed means of boosting the economy in our present time of need. The CBO has estimated that most of the stimulus money won’t be spent until late 2009, if then.
Moreover, the haste required to spend the money even by then entails risk. The more quickly the government proceeds, the more likely it is to saddle taxpayers with wasteful programs. The notion of spending $1 trillion without careful deliberation should offend even liberals, though it does not appear to.
A stimulus package that kicks in too late would not just be wasteful, but downright harmful. Significant inflation and significant deflation are both to be feared for mainly the same reason – they upset expectations and thus are hugely destabilizing.
A vast infusion of government money right now might well prevent a disastrous deflation. Such an infusion a year and a half from now, when the economy may be recovering, could spur an equally ruinous hyper-inflation.
Liberal Democrats, who hope to use the stimulus package to bring about a permanent increase in the size and scope of the federal government, seem willing to assume the inflationary risk. The rest of us should not be.
Tax cuts avoid most of these drawbacks. The tax cut of choice is the payroll tax. According to John Mackin of the American Enterprise Institute, if the payroll tax were suspended for a year to 18 months, households would receive a 3.5 percent boost in disposable income.
Not all of this money would be spent, of course. Some would be saved or used to pay down debt. But these purposes are not to be despised.
Moreover, the spending increase, and hence the stimulus, would be immediate, not deferred while cumbersome government programs slowly unfold. And when the economy starts to rebound, the payroll tax holiday can (and should) be ended.
Timing is everything when it comes to economic stimulus. Tax policy leaves the government with control of the timing, albeit subject to political pressure.
A reduction in the payroll tax would have additional benefits on the employment side. It would reduce the cost of retaining employees, and thereby reduce the incentive to lay employees off. Employers would still need to reduce costs, but would be less inclined to do so by slashing their payroll.
A payroll tax holiday would not be without disadvantages. The obvious one is a massive increase in debt. The associated costs include inflation and, as a practical matter, eventual tax increases. Moreover, excessive borrowing represents a particularly perilous course at this moment, given the impending retirement of the baby boomers.
A payroll tax holiday would not be a distinctive threat to Social Security and Medicare – these obligations need not be met through a payroll tax. But the increased borrowing required to cover the shortfall is not a happy prospect, to say the least.
Ultimately, the best response to our difficulties might well be to focus on making sure credit is available, while confining new spending to programs we should be willing to fund in normal times. Few of those contained in the Democratic package meet that standard.
But the push for a massive stimulus program seems irresistible. The stimulus that makes the most sense is tax relief, and the tax relief that makes the most sense is a payroll tax holiday.
Sunday Reflection contributor Paul Mirengoff is a lawyer in Washington, D.C., and a principal author of Powerlineblog.com.
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