More on Stimulus Spending and Other Government Interventions

by Veronique de Rugy

If you aren’t totally sick of hearing people like me talk about stimulus spending, how effective it is, and what the multiplier for government spending financed through taxes or borrowing is, you will truly enjoy this EconTalk podcast with Valerie Ramey of the University of California, San Diego (I am a fan and have written about her work). The interviewer is George Mason University’s Russ Roberts. Here are some of the things they talk about:

Ramey’s own work exploits the exogenous nature of wartime spending. She finds a multiplier between .8 and 1.2. (A multiplier of 1 means that GDP goes up by the amount of spending — there is neither stimulus nor crowding out.) She also discusses a survey looking at a wide range of estimates by others and finds that the estimates range from .5 to 2.0. Along the way, she discusses the effects of taxes as well. The conversation concludes with a discussion of the imprecision of multiplier estimates and the contributions of recent Nobel Laureates Thomas Sargent and Christopher Sims.

They have a particularly fascinating conversation about the way people respond to increases in their taxes to finance government spending. As you may recall from a previous post, the work of former Obama Council of Economic Advisers chairman Christina Romer and her economist husband, David Romer, shows how increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. In other words, the project you finance through taxes had better be productive, to justify this negative effect. It is in that context that Roberts asks Ramey to explain how to reconcile Romer and Romer’s finding with the microeconomics literature showing that labor supply — especially for men or primary earners — is relatively inelastic to changes in net tax, meaning that full-time employees don’t really seem to react much (i.e., by shifting their hours) in response to increases in their taxes.

I have been wondering about this, especially while thinking about how letting the Bush tax cuts expire would affect the labor supply and the economy. Here is what happens, Ramey explains: While it is true that increases in rates don’t seem to have much of an effect on the labor supply of the typical full-time employed men aged 30 to 50 (roughly)–this finding doesn’t hold for secondary earners–studies have shown that this is not the whole story. In recent years, labor economists have been focusing a lot of their attention to what they call the extensive margin, which is employees’ movement in and out of employment, in particular at both ends of life cycle. Economists like Nobel prize winner Edward Prescott have concluded that looking at “extensive margin” allows us to understand questions like “Why do Europeans work fewer hours in the course of their work life than American do?”

In other words, changes in tax rates don’t seem to have much of an effect on the average hours worked for typical full-time employed men between the ages of 30 and 50, but they do have an effect on younger workers and older ones. Employees may not change their labor supply at the time of the tax-rate increase, but they are likely to adjust in later years; it is also likely to affect younger workers. Basically, when looking at tax effects on labor supply, it’s lifetime hours that matter. This may be an important factors in explaining the strong negative effects of deficit reduction through tax increases. It also seems like a good reason not to raise taxes if you ask me.

The 60-minute podcast is really worth listening to. You will learn a lot.