!VAR HAGENDOORN

A Short Note on Economic Stimulus Programs

There’s currently a lot of debate among economists of name and repute about the need for and merits of an economic stimulus program. What most authors seem to ignore is that following September 11 government spending in the U.S. has increased enormously with the war in Afghanistan and Iraq and all the money spent on "home defence". This constitutes a virtual stimulus package. Leaving that aside my own view starts from a simple maxim.

Government should provide facilities that benefit the entire society: protection of people and property, infrastructure, legislation, law enforcement, healthcare, education etc. Some of these can be provided by private enterprises, but only governments can provide them indiscriminately to all citizens. It can finance this by periodically robbing other tribes, cities or states, plundering its colonies, through the sale of assets, through borrowing or by levying taxes. Modern states rely (primarily) on the latter three options (state oil companies sell a country’s assets). Since at some point the loans will have to be paid back, borrowing effectively comes down to deferred taxes.

Additionally, most governments also see it as their task to adjust the behaviour of citizens and manufacturers by levying taxes on products the consumption and production of which it wishes to discourage and by subsidizing those goods which it deems beneficial. The problem is that the effects of a price increase (decrease) on consumption depends on the price elasticity of demand of the product in question, which is influenced by numerous factors such as the number of close substitutes for a good, the cost of switching between different products, whether the good is a luxury item or a necessity, whether it is subject to habitual consumption and how big a percentage of income a consumer spends on it. Thus, in general I am sceptical about the use of fiscal incentives to influence consumer behaviour. (I am less sceptical about the effects on manufacturing as long as the incentives are strong enough).

In principle I’m of the opinion that in the long run a government should stick to what it should do as summarized in the above maxim. In doing so it should strive for a balanced budget since in the long run annual deficits are unsustainable. In the short term, if a country’s government is worried about the consequences of, say, a reduction in economic growth, it may decide to shift some of its expenditures forward in time or temporarily re-prioritize some of its actions. What's more, because during an economic downturn the income from taxes will fall, to maintain a balanced budget the government would have to cut back on its budget. Therefore sticking to its long term budget plan also amounts to a (virtual) stimulus program.

I am however sceptical about the possibilities for governments to influence business cycles in the short term and about the effects of stimulus packages in general. My scepsis is given in by theoretical and empirical considerations. The effect of stimulus measures depends on the nature of a country's economy. For instance the effect of measures aimed at private consumption depends on private consumption's share of GDP as well as the level of imports.

Following the re-unification in 1989 of Germany the German government poured billions into the former Eastern Germany and both domestic and foreign companies were given large tax benefits if they invested there. But unemployment is still higher and the region lags other regions in terms of economic development. What's more economic growth in the re-unified Germany as a whole fell behind that of other countries in Europe. (Just read this paper). What if instead government had let economic geographic dynamics take care of itself?

What is happening now in the U.S. and other countries is that instead of sticking to the long term maxim mentioned above on the one hand state and local governments are messing around with tax cuts here, subsidies there and budget cuts and tax increases everywhere to make ends meet while on the other hand governments are planning increases in spending to stimulate the economy.

The amended TARP plan which passed congress on 1 October included, among other things, an exemption from excise tax for wooden arrows designed for use by children (sec. 503), a tax benefit for bicycle commuters that allows employers to pay for employee bike repair (sec. 211) and an extension of mine rescue team training credit (sec. 310). What is this doing in a Troubled Asset Relief Plan?

In its budget plan for the next fiscal year the state of New York announced a tax levy on sugary soft drinks, increases in taxes on car rentals, alcoholic beverages, increases in tuition fees, cuts in healthcare and so on. The state of California suspended construction work on schools, roads and hospitals for half a year, cut university and education budgets etc.

On the one hand we have ridiculous taxes and on the other hand we have spending cuts that will actually impede long term economic growth.

All of this shows to me that there is something fundamentally wrong with fiscal policy and government policy in general. Having said so, this is the current reality, so it's best to adjust your own plans accordingly. But that's another story.

Links

More scepsis.