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Tuesday, June 14, 2011

Aspirational Goals Can Distort Policy and Make Us Worse Off

John Taylor encourages policymakers to shoot at unattainable economic growth goals. But he of all people should know that when the Fed targets output growth in excess of potential growth, it can be highly inflationary (he argues he isn't doing this, that 4.7% growth is a reasonable goal to "aspire" to, but there's nothing in our history to suggest this level of growth is sustainable over the long-run).

Ah, you say, but fiscal policy is different. Actually it isn't. Suppose you've hit a 3.5% growth rate, and that is potential growth, but your goal is 5%. That will cause you to put policies into place -- more tax cuts if it's up to Republicans -- to try to hit the higher growth target. This distorts policy and captures resources that could be used better elsewhere.

To see this, imagine an economy at its long-run potential for output growth, and with some level of taxation to support government. To make it simple, assume the tax rate is optimal, i.e. the level consistent with welfare maximization. Now raise the target for growth above the long-run sustainable level (perhaps based upon incomplete or faulty information or the ability to fool people who are less than fully informed). That will cause additional tax cuts, perhaps targeted at investment, and then more and more tax cuts and other policies as the economy continues to fall short of target, The result is that the economy will be driven to a new equilibrium (or sequence of equilibrium points if tax cuts are ratcheted down in pursuit of the target), one based upon an unattainable aspiration, i.e. a growth rate that cannot be sustained in the long-run (essentially, the economy is no longer at the full information solution). Since the previous equilibrium point was optimal, moving away from it makes us worse off.

    Posted by on Tuesday, June 14, 2011 at 06:30 PM in Economics, Fiscal Policy, Policy | Permalink  Comments (20)


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