Evan Soltas
Feb 13, 2012

Stimulating Discussions

Good and bad times to call for spending or tax cuts

One of those basic macroeconomics questions concerns the nature of countercyclical fiscal policy: when, and to what extent, should governments use increases in direct expenditure/investment versus decreases in net taxes (tax revenue minus transfer payments).

In short: When are tax cuts better? When is government spending better?

First, a brief interlude. Despite the language of some Republicans, I'd like to note here that cutting taxes without a concomitant cut in spending is as much an activist fiscal policy as is President Obama's budget proposal. Thus is the nature of "net" changes in math. There seems to be quite a bit of confusion on this point.

Yet while a tax cut and a spending increase will have the same effect on the federal deficit, the same equivalence is not the case for its effect on real output. This implies that the choice between a demand-side (i.e. government spending) and supply-side (i.e. tax cut) stimulus should be seen as a positive, not a normative, policy decision. That is, there is a right answer, and a wrong one, to this question. This is not a situation of two equally valid opinions.

(This post does not contest the choice between fiscal policy and alternatives, namely monetary policy. It solely considers what the ideal fiscal stimulus is, not whether fiscal stimulus is ideal per se.)

What this question boils down to, as seen in the textbook macroeconomics and the vast body of supporting literature, is a weighing of two considerations:

  1. The tax multiplier is substantially lower than the multiplier for changes in spending. This is because some of the money is saved in the first "round" of spending from a tax cut, whereas the government spends everything in the first "round" of multiplier effects.
  2. The slope of the aggregate supply curve determines to what extent a change in demand will realize a change in real output, rather than just a change in prices, and the extent to which a change in supply will between output and prices.
Demand-side policy makes positive economic sense when demand is low, output is very low relative to potential, and any increase in demand will be met by suppliers through increases in output rather than prices. At such a time, the larger multiplier of direct government spending (as compared to changes in net taxes) is the key consideration. A further increase in supply would serve to do little in terms of real output; indeed, there is some evidence that in such circumstances, the resulting drop in the price level may actually undermine recovery in real output. (Look at the chart on the right to see that an increase in demand, as represented by the rightward shift in the AD curve, would sharply increase real output without a meaningful change in prices when output is far below potential. Simultaneously, an increase in supply, which you could imagine by shifting the AS curve to the right, is impotent.)

Supply-side policy makes positive economic sense when any increase in demand will be met by suppliers through increases in prices rather than output--i.e. demand is high, and output is near potential. At such a time the multiplier from spending has been muted by the slope of the aggregate supply curve. Shifting the supply curve out, by contrast, has a much stronger impact on real output because of how the vertical section of it effectively caps output. Therefore any policy which can shift out the AS curve, even if its impact on AD is smaller, is the ideal. (Look at the chart on the left to see that an increase in demand without shifting supply is weak; but a rightward shift in the AS curve is effective in increasing output.)

So let's get a few things straight. Spending and tax cuts have equivalent effects on the fiscal deficit. They do not have equivalent effects on output. And economists have positive knowledge as to when to use one or the other, given macroeconomic conditions.