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Wednesday, February 11, 2009

Multipliers and the Role of Government

I think it would be fair to say that most economists believe that both tax and government spending multipliers are non-zero, though we disagree about which of the two is bigger.

But if both tax cuts and government spending can get the job done, and the differences aren't that large, I don't think most people who aren't economists care which is bigger, the choice depends upon other things. Suppose, e.g., that the tax multiplier is 1.25 and the government spending multiplier is 1.50. Then it would take a change in taxes of $600 to produce the same effect as changing government spending by $500, but so long as the amount is adjusted according to the magnitude of the multiplier, the impact on the economy will be the same.

Because of this rough equivalence, many people opposed to the stimulus bill aren't opposed because they think that government spending won't work, the issue is, plainly and simply, the size of government and its role in the economy.

To explain, note that there are two means of conducting fiscal policy, changing government spending (G), and changing taxes (T), and also note that which is used can have an effect on the size of government. For example, suppose government operates as follows:

In recessions G is increased which increases the deficit, then T is increased during booms to pay for it (that's how it's supposed to work anyway). The overall effect is to attenuate swings in output during both the boom and the recession and thereby stabilize the economy over time.

Now apply this over and over, increase G in a recession, increase T to pay for it after the recovery, increase G in the next recession, then increase T again, and so on. The result is that G increases in every recession with T subsequently increased to pay for it, and government grows over time.

Now try a second strategy that switches the role of taxes and government spending:

Taxes are cut during recessions, then government spending is cut during the boom to pay for it. During the next cycle, this repeats, T goes down during the recession, G is then cut to pay for it once things get better, and so on. In this case, the size of government gets smaller over time.

Of course, it's also possible to keep the government the same size by choosing one tool and sticking with it, T down in recession, T up in recoveries, or, alternatively, G up in recessions, G down in recoveries (and more creative combinations of changes in G and changes in T will work too), so the size of government is a policy choice.

So, for many people, I don't think the real issue is about whether government spending multipliers are bigger or smaller than tax multipliers, as I said above I think most economists and the public more generally believe both types of policies can work (if they are implemented correctly), the differences aren't that large, and nobody knows for sure which is better. The real issue is about the role of government in the economy, some think it is too big and they support tax cuts to cure recessions, others see (correctly in my view) important unmet needs for infrastructure, health care reform, environmental initiatives, and so on, and they see government spending as the key to solving both the short-run and longer run issues.

So while the argument may appear to be about the relative size of multipliers, the choice of which type of policy to emphasize is largely driven by other issues.

    Posted by on Wednesday, February 11, 2009 at 01:17 AM in Economics, Fiscal Policy, Politics | Permalink  TrackBack (0)  Comments (80)


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