Stabilization Policy

Currently, there are quite a few people advocating the use of tax cuts to combat a potential slowdown in the economy due to the financial crisis. That is certainly an option, if the tax cuts are well-targeted so that they do, in fact, provide the intended stimulus to the economy, and if they can be put into place quickly enough to hit before the economy recovers on its own. But there is another aspect of using tax cuts for stabilization policy that needs to be in place that would be difficult to achieve in the current political environment.

If we are going to use tax cuts as a fiscal policy tool to stabilize the economy, we have to be willing to move the tax rate in both directions, up as well as down. We are quite willing, currently, to move the tax rate down but when people like Martin Feldstein call for a temporary tax cut to stimulate the economy, if such a policy were to be enacted does anyone doubt the difficulty of raising taxes again later even with automatic expiration provisions?

Backing up slightly, why do we need to increase taxes again instead of leaving them where they are? This is stabilization policy, not growth policy, and the goal is to keep the economy anchored as closely as possible to the target rate of output. If in each successive business cycle the tax rate is lowered, but it is never raised again, there will eventually come a time when the tax rate cannot be lowered any further. If a severe recession then hits, and monetary policy isn't providing the needed stimulus or interest rates are already so low that further decreases will be ineffective, then fiscal policy will be unavailable as a backup stimulus device, much to our detriment.

Instead, assuming as in most models that the target rate of output is centrally located, the goal is to bring the economy up when the economy is dragging (use tax cuts that increase the deficit) and to slow the economy down when it begins to overheat (use tax increases that reduce the deficit). Managed properly over business cycles, tax cuts in bad times, tax increases in good times, the economy will stabilize around the target and there will be no long-run consequences for the deficit or the size of government. But if we insist that only tax cuts are available, that there is a ratchet effect in place and taxes can never be increased again, then - abstracting for the moment from changes in government spending or assuming that changes in spending are infeasible for use as a stabilization tool -  at some point we could well run out of options.

There is nothing special about using tax changes for stabilization policy, changes in government spending can also be used. Changes in government spending may even be preferred in some cases, and combinations of changes in government spending and changes in taxes can also be used to stabilize the economy around the long-run growth path if that is the preference. Want a smaller government? Use tax cuts to stimulate the economy in recessions, and use reductions in government spending to slow the economy when it threatens to overheat and be inflationary. Want a larger government? Do the opposite, increase government spending whenever the economy is lagging, and increase taxes to slow the economy when it begins to overheat.

The point is that stabilization policy - changes in taxes or changes in government spending - does not necessarily change the size of government in any particular direction, that is a policy choice. Traditionallyf stabilization policy maintains a constant budget balance in the long-run and whether to use tax changes or spending changes is a matter of effectiveness, not a matter of ideology about the size of government. Unfortunately, disputes over this issue can make it difficult to use fiscal policy as a stabilization tool. Even when both sides agree something needs to be done, different ideas about the size and functions of government can cause differences in the choice of tax changes or changes in spending as the means of stimulating or slowing the economy leading to policy gridlock.

In the political arena, gridlock can also occur when growth policy and stabilization policy are confused in order to block certain types of policies. For example, a tax increase during a robust economic expansion to pay off the tax cut enacted in the previous slowdown may be blocked by objections that it will slow economic growth. But that is the point of the policy in the short-run - the increase in the tax rate is supposed to stop the economy from overheating - just as the cut in taxes was intended to stimulate the economy on the other side. It's the average tax rate over the long-run that matters for for growth (the stability of taxes also matters which is one of the reasons to prefer changes in government spending over changes in taxes as the stabilization tool). Politically, in the current environment, it is difficult to do anything to pay off the debt when the economy is expanding, increases in taxes or cuts in spending, because one of the primary objections is that it will slow growth. But if we are serious about stabilization policy we have to somehow realize that the good times are the best choice for paying off the debts we accumulated when things weren't going so well.

Here's David Wessel touching upon some of the same issues in his latest Capital column for the WSJ. The discussion above was mainly about fiscal policy, particularly the choice between taxes and spending as the primary fiscal policy instrument. This is a nice summary of the issues involved in a different policy choice, whether to use monetary policy or fiscal policy to stimulate the economy:

Don't Count on a Stimulus Plan, by David Wessel, WSJ: With the Federal Reserve struggling to find the right medicine for a sickly economy that may be resistant to traditional remedies, talk of using fiscal stimulus -- spending increases or tax cuts -- is growing louder.

For years, the conventional wisdom ... has been that recession-fighting is best left to the Fed. It can cut interest rates quickly when the economy weakens. Fiscal stimulus, the argument goes, is a great idea -- in theory. The reality is that Congress and the president inevitably move so slowly that the stimulus arrives too late...

Yes, a sluggish economy got a well-timed boost from the Bush tax cuts in 2001, but the past quarter century suggests that relying on the Fed to fight recession usually works. Still, when deficit-fearing Harvard University economists Martin Feldstein ... and Lawrence Summers ... begin prescribing fiscal stimulus (and when former Fed Chairman Alan Greenspan -- incorrectly, by the way -- is viewed as a fellow traveler), it's time to listen carefully.

That the economy needs help isn't at issue. The issue is whether to mix fiscal stimulus with monetary policy... What are the arguments for doing so?

• The Fed isn't doing enough because it doesn't realize how ill the economy truly is. This case is built on the premise that the White House and Congress are better than the Fed at diagnosing the short-term swings in the economy. And it ignores the fact that the Fed could offset a fiscal stimulus it deemed imprudent by keeping interest rates higher than they would otherwise be. A lousy argument.

• The Fed's rate cuts aren't working ... as usual amid the widespread reluctance of lenders to lend. True... This bolsters the case for fiscal stimulus, but makes a better argument that the Fed and ECB need to be more aggressive.

• The Fed can't cut rates because it fears a dollar crash. At the Fed, the gradual decline in the dollar is viewed as a tonic for the economy; it'll help boost exports, though it does exacerbate the central bank's inflation anxiety. But cutting rates too much too fast could trigger a market-rattling, confidence-shaking plunge in the dollar. To the extent that specter stands in the way of the Fed..., then tax cuts or spending increases are indicated. Stronger argument.

• The usual channels through which Fed monetary policy works are clogged. Lower interest rates usually help... in part by stimulating housing construction. But housing is such a mess now that trimming the Fed's target interest rate ... wouldn't have the usual oomph. ... Strong argument, unless conditions improve significantly in the next several weeks.

• The Fed can make decisions swiftly, but, as Nobel laureate Milton Friedman taught, monetary policy works with long and variable lags. Giving Americans money to spend -- for example, through a tax cut that shows up in their paychecks next spring -- could have a much quicker impact on consumer spending. If, and this is a huge if, Congress and the president move swiftly, they could complement the Fed's efforts.

That really is the big rub. ..: Do it soon. Aim it at people who will spend the money. Don't worsen the long-term government deficit. History isn't encouraging about the likelihood of quick action. President Bush and Democrats in Congress agree on almost nothing these days. ... [And on the deficit,] Laurence Meyer, a former Fed governor [says]: "There's no such thing as a temporary tax cut anymore..."...

Turn from what the fiscal physicians are prescribing to what is actually likely to happen. That is what Mr. Greenspan is doing. He would prefer politicians do nothing, letting housing prices (and securities pegged to mortgages) fall until investors see them as bargains and start buying, stabilizing the economy. But with so many homeowners in pain and so much anxiety about the economy, he knows politicians want to do something. He says he would rather they offer "emergency aid, similar to what government does in natural disasters," than tear up contracts between borrowers and lenders or prop up housing prices and prolong the crisis.

The ... best political forecast is that nothing will come of this talk of fiscal stimulus. But should the economy continue to deteriorate early next year, or if a big financial institution totters, or if the Fed looks impotent or paralyzed, talk will give way to action and -- if the economy looks bad enough -- could produce legislation that President Bush might accept.