print logo
RSS FEED

What Should We Expect from Fiscal Stimulus?

Tuesday, February 10, 2009

There is still much that we do not know about the proper design of fiscal stimulus.

The stimulus package currently making its way through Congress is designed to address what some have described as “a crisis not seen since the Great Depression.” Economists generally agree that some form of government intervention is needed and policymakers seem poised to act quickly. But there is wide debate over the efficacy of the current proposal. What are reasonable expectations for this countercyclical discretionary stimulus?

Stimulating demand is useful in moderating business cycle fluctuations because it can provide a temporary boost in output, if timed properly. In the long run, economic growth is driven by an economy’s natural productive capacity. However, since certain frictions exist in an economy in the short run—such as sluggish adjustment of prices and nominal wages—output can depend on the economy’s short-term demand for goods and services rather than its natural output level.

When aggregate demand is increased through new government spending, output temporarily increases relative to its natural level, but is likely to be accompanied by a “payback” period in which output is temporarily reduced relative to its natural level. Rather than attempting a permanent change in output, the goal of fiscal stimulus should be stabilization: a boost in demand during downturns at the expense of future output. The best use of fiscal stimulus is to keep output close to its natural level by offsetting the impact of other fluctuations in aggregate demand.

Allowing greater ‘carrybacks’ of net operating losses is likely to provide a useful, although small, stimulus effect while also reducing tax penalties on riskier investment.

To stabilize economic activity, economists usually favor the use of monetary policy over fiscal stimulus because it can be implemented quickly and managed with close precision by the Federal Reserve. In the current setting, where short-term interest rates are near zero, monetary policy alternatives are limited. Although discretionary fiscal stimulus is subject to timing and implementation lags, it can be applied at any interest rate, making it a potentially useful policy alternative now.

The relative merits of two major types of fiscal stimulus—government purchases and tax rebates—are widely debated in public policy circles. In a simple textbook analysis, government purchases of goods and services increase GDP by more than tax rebates, because 100 percent of an increase in government purchases will be pumped into the economy, whereas part of a tax rebate could be saved or spent abroad.

In the real world, the comparison between tax rebates and government purchases is more complicated and depends upon the value of the specific spending category. In the textbook example, the value of the government purchases, say the construction of a new bridge, is assumed to equal its cost. In reality, however, the bridge could be highly valuable or it could be a “bridge to nowhere.” If a government purchase is wasteful, it squanders the time of workers while providing little economic benefit, making it inferior to a tax rebate.

The best use of fiscal stimulus is to keep output close to its natural level by offsetting the impact of other fluctuations in aggregate demand.

One tax cut option that has been criticized is worth a second look. Allowing greater “carrybacks” of net operating losses (NOLs) is likely to provide a useful, although small, stimulus effect while also reducing tax penalties on riskier investment. Firms with losses on their tax returns are currently allowed to “carry back” their losses to offset any taxable profits in the two preceding years and to claim refunds of taxes paid in those years. One proposal included in the stimulus plan would allow carrybacks of up to five years, thereby benefiting firms that would otherwise have unused loss deductions and therefore gain no current tax benefit for undertaking new investment. More generous NOL carryback provisions would also reduce tax penalties on businesses’ riskier investments by allowing losses to be deducted in economic downturns, counterbalancing the taxes paid on profits in upturns.

There is still much that we do not know about the proper design of fiscal stimulus. One thing we can be sure of is that every dollar counts.

Alan D. Viard is a resident scholar at the American Enterprise Institute. He was a senior economist at the Federal Reserve Bank of Dallas and the White House’s Council of Economic Advisers. He is the editor of Tax Policy Lessons from the 2000s, a conference-proceedings volume recently published by AEI Press. This article is based on Viard’s Tax Policy During the Recession: The Role of Fiscal Stimulus (Tax Notes, January 12, 2009). AEI economic policy studies program manager Scott Ganz and AEI research assistant Amy Roden helped prepare this article.

Image by Darren Wamboldt/The Bergman Group.

Most Viewed Articles

Why the Government Won't Let Colleges Reduce Tuition By Ike Brannon 09/17/2014
Congress should give permission for private colleges to cooperate in cutting their tuition. It’s ...
Closing the Racial Gap in Education By Jason L. Riley 09/10/2014
The usual explanation for the academic achievement gap is that blacks come from a lower ...
The Minimum Wage Can Never Be High Enough By Ike Brannon 09/07/2014
The minimum wage is a facile non-solution for the complicated problem of poverty in America.
Telecommuting: Good for Workers, Good for Bosses By Michael M. Rosen 09/12/2014
Challenges abound, but the trajectory is plain.
Mission Essential: Leveraging and Protecting Our Special Forces By Phillip Lohaus 09/12/2014
Military leaders must build the optimal balance between special and conventional forces, or risk ...
 
AEI