A key issue facing the new Obama administration is to what extent the economic stimulus should take the form of spending increases versus tax reduction. One way to think about the issue is the size of the fiscal policy multipliers. The multipliers measure bang for the buck–the amount of short-run GDP expansion one gets from a dollar of spending hikes or tax cuts.
So what are these multipliers? In their new blog, Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. Similarly, the results in Valerie Ramey’s research suggest a government spending multiplier of about 1.4…
By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.
As Professor Mankiw correctly notes, fiscal policy multipliers are only one way of looking at this topic (albeit a very important one). Nevertheless this work raises, to put it mildly, some interesting questions. It’s well worth reading the whole post.
Another related topic is whether the bang for the buck would vary with the type of tax that is to be cut. Would reducing Social Security taxes, for example, be more effective than cutting the capital gains rate? Then there’s the whole problem of state taxes, and the very real danger that the beneficial effect of any tax cuts at the federal level would be offset by tax hikes in the states . . .
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