Article reading and question

Journal of Economic Perspectives—Volume 24, Number 4—Fall 2010—Pages 141–164

DD uring and after the “Great Recession” that began in December 2007 uring and after the “Great Recession” that began in December 2007 (according to the Business Cycle Dating Committee at the National Bureau (according to the Business Cycle Dating Committee at the National Bureau of Economic Research), the U.S. federal government enacted several of Economic Research), the U.S. federal government enacted several rounds of activist fi scal policy. These began early in the recession with temporary rounds of activist fi scal policy. These began early in the recession with temporary tax cuts enacted in February 2008, followed by a tax credit for fi rst-time homebuyers tax cuts enacted in February 2008, followed by a tax credit for fi rst-time homebuyers enacted in July 2008. They reached a crescendo in February 2009 with the American enacted in July 2008. They reached a crescendo in February 2009 with the American Recovery and Reinvestment Tax Act (ARRA): a combination of tax cuts, transfers Recovery and Reinvestment Tax Act (ARRA): a combination of tax cuts, transfers to individuals and states, and government purchases estimated to increase budget to individuals and states, and government purchases estimated to increase budget defi cits by a cumulative amount equal to 5.5 percent of one year’s GDP. The fi scal defi cits by a cumulative amount equal to 5.5 percent of one year’s GDP. The fi scal stimulus continued thereafter with more targeted measures, notably the temporary stimulus continued thereafter with more targeted measures, notably the temporary “cash for clunkers” program in summer 2009 aimed at stimulating the replacement “cash for clunkers” program in summer 2009 aimed at stimulating the replacement of old cars with new ones, and an extension and expansion of the First-Time Home-of old cars with new ones, and an extension and expansion of the First-Time Home- buyer Credit in November 2009 and July 2010. Accompanying these fi scal efforts buyer Credit in November 2009 and July 2010. Accompanying these fi scal efforts were the Troubled Asset Relief Program, enacted in fall 2008 to address the fi nan-were the Troubled Asset Relief Program, enacted in fall 2008 to address the fi nan- cial crisis, and a continuing array of interventions by the Federal Reserve Board that cial crisis, and a continuing array of interventions by the Federal Reserve Board that aimed to stabilize credit markets and stimulate the economy.aimed to stabilize credit markets and stimulate the economy.

Around the world, other countries caught in the grip of recession also pursued Around the world, other countries caught in the grip of recession also pursued a variety of active fi scal strategies, ranging from temporary consumption tax rebates a variety of active fi scal strategies, ranging from temporary consumption tax rebates (for example, in the United Kingdom) to large public works projects (notably in (for example, in the United Kingdom) to large public works projects (notably in

Activist Fiscal Policy

■ ■ Alan J. Auerbach is the Robert D. Burch Professor of Economics and Law, University of Alan J. Auerbach is the Robert D. Burch Professor of Economics and Law, University of California, Berkeley, California. William G. Gale is the Arjay and Frances Miller Chair in California, Berkeley, California. William G. Gale is the Arjay and Frances Miller Chair in Federal Economic Policy, The Brookings Institution, Washington, D.C. Benjamin H. Harris is Federal Economic Policy, The Brookings Institution, Washington, D.C. Benjamin H. Harris is Senior Research Associate, Economic Studies Program, The Brookings Institution, Washington, Senior Research Associate, Economic Studies Program, The Brookings Institution, Washington, D.C. Their e-mail addresses are D.C. Their e-mail addresses are ⟨⟨[email protected]@econ.berkeley.edu⟩⟩, , ⟨⟨[email protected]@brookings.edu⟩⟩, and , and ⟨⟨[email protected]@brookings.edu⟩⟩..

doi=10.1257/jep.24.4.141

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris

142 Journal of Economic Perspectives

China). The prevalence of fi scal policy interventions in this period refl ects both China). The prevalence of fi scal policy interventions in this period refl ects both the severity of the recession and a revealed optimism with regard to the potential the severity of the recession and a revealed optimism with regard to the potential effectiveness of activist fi scal policy. Yet the variety of policies adopted also suggests effectiveness of activist fi scal policy. Yet the variety of policies adopted also suggests uncertainty about which approaches might have been most effective.uncertainty about which approaches might have been most effective.

In this paper, we review the recent evolution of thinking and evidence In this paper, we review the recent evolution of thinking and evidence regarding the effectiveness of activist fi scal policy. Although fi scal interventions regarding the effectiveness of activist fi scal policy. Although fi scal interventions aimed at stimulating and stabilizing the economy have returned to common use, aimed at stimulating and stabilizing the economy have returned to common use, their effi cacy remains controversial. We review the debate about the traditional their effi cacy remains controversial. We review the debate about the traditional types of fi scal policy interventions, such as broad-based tax cuts and spending types of fi scal policy interventions, such as broad-based tax cuts and spending increases, as well as more targeted policies. We conclude that while there have increases, as well as more targeted policies. We conclude that while there have certainly been some improvements in estimates of the effects of broad-based certainly been some improvements in estimates of the effects of broad-based policies, much of what has been learned recently concerns how such multipliers policies, much of what has been learned recently concerns how such multipliers might vary with respect to economic conditions, such as the credit market might vary with respect to economic conditions, such as the credit market disruptions and very low interest rates that were central features of the Great disruptions and very low interest rates that were central features of the Great Recession. The eclectic and innovative interventions by the Federal Reserve and Recession. The eclectic and innovative interventions by the Federal Reserve and other central banks during this period highlight the imprecise divisions between other central banks during this period highlight the imprecise divisions between monetary and fi scal policy and the many channels through which fi scal policies monetary and fi scal policy and the many channels through which fi scal policies can be implemented.can be implemented.

The Fall and Rise of Activist Fiscal PolicyThe Fall and Rise of Activist Fiscal Policy

Until very recently, a typical student of macroeconomics would likely be Until very recently, a typical student of macroeconomics would likely be introduced to discretionary fi scal policy through a cautionary tale of the hubris of introduced to discretionary fi scal policy through a cautionary tale of the hubris of attempts at “fi ne tuning” in earlier decades. The student would start with a group attempts at “fi ne tuning” in earlier decades. The student would start with a group of well-rehearsed arguments, beginning with the lags in the making of economic of well-rehearsed arguments, beginning with the lags in the making of economic policy and further lags in the implementation and effects after the policy is enacted, policy and further lags in the implementation and effects after the policy is enacted, which make it diffi cult for policymakers to time fi scal policy actions to stabilize the which make it diffi cult for policymakers to time fi scal policy actions to stabilize the economy. Indeed, a recession could end even before the need for action was recog-economy. Indeed, a recession could end even before the need for action was recog- nized, with government offi cials still focused, as they were in 1975, on the need to nized, with government offi cials still focused, as they were in 1975, on the need to “Whip Infl ation Now.” The student would also learn that uncertainty about policy “Whip Infl ation Now.” The student would also learn that uncertainty about policy multipliers made weaker intervention desirable (Brainard, 1967). The student multipliers made weaker intervention desirable (Brainard, 1967). The student would learn the Lucas (1976) critique, which implies that a policy’s stabilizing effects would learn the Lucas (1976) critique, which implies that a policy’s stabilizing effects can be undercut by the expectations and actions of rational agents who observe the can be undercut by the expectations and actions of rational agents who observe the government’s policy process. For example, one reason that investment might drop government’s policy process. For example, one reason that investment might drop during a recession is the anticipation that a countercyclical investment incentive will during a recession is the anticipation that a countercyclical investment incentive will be enacted in the near future. Consumption might not respond much to a counter-be enacted in the near future. Consumption might not respond much to a counter- cyclical reduction in income taxes, because the wealth effects of such tax reductions cyclical reduction in income taxes, because the wealth effects of such tax reductions are small when the reductions are seen as temporary. The intriguing notion of are small when the reductions are seen as temporary. The intriguing notion of Ricardian equivalence (Barro, 1974) would promote further skepticism about the Ricardian equivalence (Barro, 1974) would promote further skepticism about the effectiveness of fi scal policy. Finally, the student would be reminded of the alternative effectiveness of fi scal policy. Finally, the student would be reminded of the alternative tools of stabilization policy, notably the interest-rate interventions of independent tools of stabilization policy, notably the interest-rate interventions of independent central banks and the automatic stabilizers already built into the government’s tax central banks and the automatic stabilizers already built into the government’s tax and transfer systems. Indeed, prior to 2008, the student would probably learn that, and transfer systems. Indeed, prior to 2008, the student would probably learn that,

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris 143

through such alternative interventions, a “Great Moderation” in postwar economic through such alternative interventions, a “Great Moderation” in postwar economic performance had been achieved.performance had been achieved.11

This array of arguments against activist fi scal policy clearly met its match This array of arguments against activist fi scal policy clearly met its match during the Great Recession, when those policymakers not already imbued with the during the Great Recession, when those policymakers not already imbued with the Keynesian doctrine rediscovered the old-time religion in their foxholes. But it is not Keynesian doctrine rediscovered the old-time religion in their foxholes. But it is not accurate to say that activist fi scal policy was totally discredited or unpracticed in the accurate to say that activist fi scal policy was totally discredited or unpracticed in the period just before. In the United States, a resurgence in fi scal policy intervention period just before. In the United States, a resurgence in fi scal policy intervention is clearly detectable in the last decade. As shown in Auerbach and Gale (2009a), is clearly detectable in the last decade. As shown in Auerbach and Gale (2009a), simple policy reaction functions, measuring the legislated responses of federal taxes simple policy reaction functions, measuring the legislated responses of federal taxes and spending to the state of the economy and the budget, show evidence of much and spending to the state of the economy and the budget, show evidence of much stronger responses to both factors, particularly to the economy, in the period from stronger responses to both factors, particularly to the economy, in the period from the start of the George W. Bush administration through the 2007 turning point the start of the George W. Bush administration through the 2007 turning point relative to the three previous presidential administrations.relative to the three previous presidential administrations.

This recent increased countercyclical policy activism is nicely highlighted This recent increased countercyclical policy activism is nicely highlighted by the very different policy responses during the two recessions before the most by the very different policy responses during the two recessions before the most recent two. In August 1982, after a year of deep recession that still had several recent two. In August 1982, after a year of deep recession that still had several months left to run, Congress passed the Tax Equity and Fiscal Responsibility Act months left to run, Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA), scaling back the large Reagan tax cuts that had been enacted just over (TEFRA), scaling back the large Reagan tax cuts that had been enacted just over one year earlier. Legislation over the same period cut near-term federal spending. one year earlier. Legislation over the same period cut near-term federal spending. During the next U.S. recession, in October 1990, a budget summit meeting of During the next U.S. recession, in October 1990, a budget summit meeting of President Bush and Congressional leaders produced legislation aimed at reducing President Bush and Congressional leaders produced legislation aimed at reducing the defi cit. Thus, in 1982 and 1990, policymakers chose to impose fi scal discipline the defi cit. Thus, in 1982 and 1990, policymakers chose to impose fi scal discipline during a recession.during a recession.

This pattern changed in the 2000s. In 2001, as concerns about a recession This pattern changed in the 2000s. In 2001, as concerns about a recession developed, Congress added a set of cash rebates to the original set of proposed developed, Congress added a set of cash rebates to the original set of proposed Bush tax cuts in order to help stimulate the economy in the short run. In early 2002, Bush tax cuts in order to help stimulate the economy in the short run. In early 2002, in response to the 2001 recession that was not then known to have ended, Congress in response to the 2001 recession that was not then known to have ended, Congress introduced “bonus depreciation,” the fi rst use of countercyclical investment incen-introduced “bonus depreciation,” the fi rst use of countercyclical investment incen- tives since the 1970s. In 2003, further individual tax rebates were enacted, as part of tives since the 1970s. In 2003, further individual tax rebates were enacted, as part of a package that focused mainly on other changes. Early 2008 saw the fi rst round of a package that focused mainly on other changes. Early 2008 saw the fi rst round of fi scal stimulus during the Great Recession, adopted just two months after the expan-fi scal stimulus during the Great Recession, adopted just two months after the expan- sion was later determined to have ended and at a time when few economic forecasts sion was later determined to have ended and at a time when few economic forecasts predicted a deep recession. For example, the Congressional Budget Offi ce (2008b) predicted a deep recession. For example, the Congressional Budget Offi ce (2008b) economic outlook for 2008 and 2009—released in March 2008—forecasted real economic outlook for 2008 and 2009—released in March 2008—forecasted real GDP growth rates of 1.9 percent and 2.3 percent and unemployment rates of 5.2 GDP growth rates of 1.9 percent and 2.3 percent and unemployment rates of 5.2 and 5.5 percent, respectively. While some of the explanation for this quicker and and 5.5 percent, respectively. While some of the explanation for this quicker and more sustained resort to fi scal policies may lie in the relaxation of budget rules, more sustained resort to fi scal policies may lie in the relaxation of budget rules, which made countercyclical fi scal interventions easier (Auerbach, 2008) and some which made countercyclical fi scal interventions easier (Auerbach, 2008) and some

1 Stock and Watson (2002) argue that the decline in economic volatility can be attributed to a mix of a more aggressive Federal Reserve policy towards infl ation, less volatile productivity and commodity price shocks, and certain unknown factors. Kahn, McConnell, and Perez-Quiros (2002) and Davis and Kahn (2008) attribute decreased volatility to improved inventory management, especially in the durable goods sector; Davis and Kahn (2008) fi nd no corresponding decline in wage, income, and household consumption volatility.

144 Journal of Economic Perspectives

may lie in the politics of tax cuts and their support by the Bush administration, may lie in the politics of tax cuts and their support by the Bush administration, developments in economic theory and evidence had also provided a stronger foun-developments in economic theory and evidence had also provided a stronger foun- dation for at least some discretionary policy interventions.dation for at least some discretionary policy interventions.

Fiscal Models and Fiscal MultipliersFiscal Models and Fiscal Multipliers

Besides the timing of fi scal changes, discussed above, the strength of activist Besides the timing of fi scal changes, discussed above, the strength of activist fi scal policy is a central issue regarding such interventions. The effect of policy is fi scal policy is a central issue regarding such interventions. The effect of policy is typically measured via a multiplier. The multiplier is the ratio of the rise in GDP rela-typically measured via a multiplier. The multiplier is the ratio of the rise in GDP rela- tive to the size of the policy intervention (the reduction in taxes and/or increase in tive to the size of the policy intervention (the reduction in taxes and/or increase in government purchases), with both terms defi ned more carefully below. A multiplier government purchases), with both terms defi ned more carefully below. A multiplier of 1 means that GDP rises by the size of the fi scal intervention. A multiplier greater of 1 means that GDP rises by the size of the fi scal intervention. A multiplier greater than 1 means the economy grows by more than the stimulus. A multiplier between 0 than 1 means the economy grows by more than the stimulus. A multiplier between 0 and 1 indicates that the economy grows, but by less than the actual stimulus. While a and 1 indicates that the economy grows, but by less than the actual stimulus. While a larger multiplier is, of course, a better outcome when a policy is aimed at increasing larger multiplier is, of course, a better outcome when a policy is aimed at increasing economic activity, a positive multiplier of any size indicates that the policy raises economic activity, a positive multiplier of any size indicates that the policy raises GDP. For a tax cut or an increase in transfer payments (which do not alter GDP GDP. For a tax cut or an increase in transfer payments (which do not alter GDP directly), the multiplier represents the increase in both the aggregate economy directly), the multiplier represents the increase in both the aggregate economy and private sector activity. For government purchases, the increase in private sector and private sector activity. For government purchases, the increase in private sector activity per dollar of government purchases equals the multiplier minus one. Thus, activity per dollar of government purchases equals the multiplier minus one. Thus, a multiplier of less than 1 for an increase in purchases would indicate that some a multiplier of less than 1 for an increase in purchases would indicate that some private sector activity is being “crowded out.”private sector activity is being “crowded out.”22

In any analysis, it is important to clarify the defi nition of the multiplier In any analysis, it is important to clarify the defi nition of the multiplier employed, since both the size of the policy intervention and the effect on GDP vary employed, since both the size of the policy intervention and the effect on GDP vary over time for most policies. Some studies relate the cumulative change in GDP to over time for most policies. Some studies relate the cumulative change in GDP to the cumulative change in taxes or spending over some relevant term, typically fi ve the cumulative change in taxes or spending over some relevant term, typically fi ve years or less, while others relate the peak change in GDP to the peak change in the years or less, while others relate the peak change in GDP to the peak change in the policy variable, with the most natural defi nition somewhat dependent on the timing policy variable, with the most natural defi nition somewhat dependent on the timing and duration of the policy intervention. There is no single “right” way to perform and duration of the policy intervention. There is no single “right” way to perform the calculation, and qualitative comparisons across policies and studies sometimes the calculation, and qualitative comparisons across policies and studies sometimes fail to specify the exact multiplier concept used.fail to specify the exact multiplier concept used.

The effects of fi scal policy can usefully be divided into direct effects and The effects of fi scal policy can usefully be divided into direct effects and economywide effects. For some policies, such as the rebates introduced earlier in economywide effects. For some policies, such as the rebates introduced earlier in the decade, data at the individual level can be used to estimate responses. Similar the decade, data at the individual level can be used to estimate responses. Similar approaches can be used to estimate the effect of tax incentives on investment, approaches can be used to estimate the effect of tax incentives on investment, although this line of research has proved challenging for several reasons. We although this line of research has proved challenging for several reasons. We review some estimates from both of these literatures in some detail below. These review some estimates from both of these literatures in some detail below. These approaches, however, only estimate the direct responses to tax changes and not the approaches, however, only estimate the direct responses to tax changes and not the

2 The discussion above refers to tax cuts or spending increases, in which case a positive multiplier indicates a positive effect on GDP. As discussed later in the paper, there is a possibility that fi scal consoli- dation—that is, a cut in government purchases or an increase in taxes—could boost GDP, in which case the resulting multiplier would be negative.

Activist Fiscal Policy 145

effects on economywide activity, which could be smaller or larger than the direct effects on economywide activity, which could be smaller or larger than the direct effects. As a result, we review a variety of models that take account of the various effects. As a result, we review a variety of models that take account of the various additional channels through which tax cuts, transfers to individuals and states, and additional channels through which tax cuts, transfers to individuals and states, and increases in government purchases affect GDP and its components.increases in government purchases affect GDP and its components.

Direct EffectsDirect Effects Tax cuts to stimulate consumption have a long history. These policy efforts have Tax cuts to stimulate consumption have a long history. These policy efforts have

generated a substantial literature, reviewed in greater detail in Auerbach and Gale generated a substantial literature, reviewed in greater detail in Auerbach and Gale (2009a), that offers several fairly robust results about the marginal propensity to (2009a), that offers several fairly robust results about the marginal propensity to consume (MPC) out of tax cuts.consume (MPC) out of tax cuts.

First, consistent with standard life-cycle and permanent-income models, most First, consistent with standard life-cycle and permanent-income models, most of the evidence suggests that household consumption responds more vigorously to of the evidence suggests that household consumption responds more vigorously to tax changes that are plausibly expected to be longer-lasting than to changes that tax changes that are plausibly expected to be longer-lasting than to changes that are expected to be shorter-lasting, with estimates of a MPC of 0.9 for long-lived poli-are expected to be shorter-lasting, with estimates of a MPC of 0.9 for long-lived poli- cies. Second, household responses to a given tax cut are heterogeneous. As theory cies. Second, household responses to a given tax cut are heterogeneous. As theory predicts, borrowing-constrained households tend to have a larger MPC out of tax predicts, borrowing-constrained households tend to have a larger MPC out of tax cuts than do other households, and low- and middle-income households are more cuts than do other households, and low- and middle-income households are more likely to be borrowing-constrained than upper-income households. Third, the effect likely to be borrowing-constrained than upper-income households. Third, the effect of tax changes on consumer spending tends to occur when the policy change is of tax changes on consumer spending tends to occur when the policy change is implemented, not when it is enacted or credibly announced.implemented, not when it is enacted or credibly announced.33

While these three fi ndings are generally consistent with standard optimizing While these three fi ndings are generally consistent with standard optimizing behavior in a setting where some households face borrowing constraints, other behavior in a setting where some households face borrowing constraints, other results suggest the importance of an additional set of factors—namely, the way results suggest the importance of an additional set of factors—namely, the way tax cuts are described and delivered. These results are consistent with a growing tax cuts are described and delivered. These results are consistent with a growing literature indicating that framing, presentation, and other factors, such as default literature indicating that framing, presentation, and other factors, such as default specifi cations, have a signifi cant infl uence on saving behavior, and therefore are specifi cations, have a signifi cant infl uence on saving behavior, and therefore are relevant because saving and consumption choices are closely linked. For example, relevant because saving and consumption choices are closely linked. For example, some evidence from survey data suggests that adjustments to tax withholding that do some evidence from survey data suggests that adjustments to tax withholding that do not represent tax cuts can nevertheless affect consumption (Shapiro and Slemrod, represent tax cuts can nevertheless affect consumption (Shapiro and Slemrod, 1995). Households appear to adhere more closely to standard model predictions 1995). Households appear to adhere more closely to standard model predictions when the policy-induced changes in income are large (Hsieh, 2003).when the policy-induced changes in income are large (Hsieh, 2003).

Comparing estimated marginal propensities to consume for the 2001 and Comparing estimated marginal propensities to consume for the 2001 and 2008 tax cuts provides interesting perspectives on two issues noted above—the 2008 tax cuts provides interesting perspectives on two issues noted above—the role of tax cut permanence and of heterogeneous responses. The 2001 rebate was role of tax cut permanence and of heterogeneous responses. The 2001 rebate was clearly—even at the time of enactment—part of a longer-lasting tax cut, whereas clearly—even at the time of enactment—part of a longer-lasting tax cut, whereas the 2008 rebate was explicitly a one-time event. On the other hand, the 2001 rebate the 2008 rebate was explicitly a one-time event. On the other hand, the 2001 rebate

3 For evidence on the marginal propensity to consume from short-lived policies, see for example Blinder (1981), Blinder and Deaton (1985), and Poterba (1988); for corresponding evidence on the marginal propensity to consume from longer-lived policies, see Souleles (2002) and Johnson, Parker, and Souleles (2006). For evidence on the links between borrowing constraints and a higher marginal propensity to consume, see for example Johnson, Parker, and Souleles (2006), Broda and Parker (2008), Agarwal, Liu, and Souleles (2007), and Bertrand and Morse (2009). For evidence that the policy effects occur after implementation, see for example Campbell and Mankiw (1989), Wilcox (1989), Parker (1999), Souleles (1999, 2002), Poterba (1988), Blinder and Deaton (1985), Johnson, Parker, and Souleles (2006), Broda and Parker (2008), and Watanabe, Watanabe, and Watanabe (2001).

146 Journal of Economic Perspectives

went to all income groups and was not refundable, whereas the 2008 rebate was went to all income groups and was not refundable, whereas the 2008 rebate was limited to low- and middle-income households and was refundable. (A refundable limited to low- and middle-income households and was refundable. (A refundable tax rebate is available in full even to individuals who owe no taxes or whose liability tax rebate is available in full even to individuals who owe no taxes or whose liability is smaller than their refund amount.) The fi rst difference should raise the MPC out is smaller than their refund amount.) The fi rst difference should raise the MPC out of the 2001 rebate relative to 2008; the second difference should reduce it. In fact, of the 2001 rebate relative to 2008; the second difference should reduce it. In fact, estimated MPCs are not signifi cantly different for the two tax cuts. For example, estimated MPCs are not signifi cantly different for the two tax cuts. For example, Broda and Parker (2008) examine micro data on household purchases and fi nd Broda and Parker (2008) examine micro data on household purchases and fi nd that households consumed about 20 percent of the rebate in the fi rst month after that households consumed about 20 percent of the rebate in the fi rst month after receiving it, a rate of consumption that is consistent with the MPC out of the 2001 tax receiving it, a rate of consumption that is consistent with the MPC out of the 2001 tax cuts reported in Johnson, Parker, and Souleles (2006). Shapiro and Slemrod (2003, cuts reported in Johnson, Parker, and Souleles (2006). Shapiro and Slemrod (2003, 2009) report the results of asking respondents in phone surveys how they intended 2009) report the results of asking respondents in phone surveys how they intended to use the 2001 and 2008 tax cuts, respectively, and report a remarkable similarity to use the 2001 and 2008 tax cuts, respectively, and report a remarkable similarity in overall responses for the two tax cuts. For example, 21.8 percent of households in overall responses for the two tax cuts. For example, 21.8 percent of households said they would mostly spend the 2001 tax cut, compared to 19.9 percent for the said they would mostly spend the 2001 tax cut, compared to 19.9 percent for the 2008 tax cut.2008 tax cut.

The literature on the effect of federal transfers on consumption is not as extensive The literature on the effect of federal transfers on consumption is not as extensive as analysis of tax cuts, but it shows clearly that transfer payments do affect household as analysis of tax cuts, but it shows clearly that transfer payments do affect household consumption. Gruber (1996, 1997) demonstrates strong effects on contemporaneous consumption. Gruber (1996, 1997) demonstrates strong effects on contemporaneous consumption from increases in welfare payments and unemployment insurance bene-consumption from increases in welfare payments and unemployment insurance bene- fi ts, respectively. Edwards (2004) estimates a marginal propensity to consume out of fi ts, respectively. Edwards (2004) estimates a marginal propensity to consume out of Earned Income Tax Credit payments of approximately 0.7. Barrow and McGranahan Earned Income Tax Credit payments of approximately 0.7. Barrow and McGranahan (2000) also fi nd strong effects of EITC receipts on spending.(2000) also fi nd strong effects of EITC receipts on spending.

Several studies examine the responsiveness of business fi xed investment to Several studies examine the responsiveness of business fi xed investment to changed investment incentives. But estimating investment responses is a consider-changed investment incentives. But estimating investment responses is a consider- ably more challenging exercise, for at least two reasons. First, there are relatively ably more challenging exercise, for at least two reasons. First, there are relatively few natural experiments providing changes in investment incentives; there were few natural experiments providing changes in investment incentives; there were essentially no changes in the tax treatment of investment between 1986 and 2002. essentially no changes in the tax treatment of investment between 1986 and 2002. Second, investment decisions are more diffi cult to model, in part because of the Second, investment decisions are more diffi cult to model, in part because of the interaction of different tax provisions (notably those that affect a fi rm’s fi nancial interaction of different tax provisions (notably those that affect a fi rm’s fi nancial policy and that limit the ability of fi rms to utilize tax deductions).policy and that limit the ability of fi rms to utilize tax deductions).

A series of studies has focused on the effects of tax changes on the composition A series of studies has focused on the effects of tax changes on the composition of business fi xed investment, primarily using panel data on fi rms, industries, or of business fi xed investment, primarily using panel data on fi rms, industries, or asset categories (for example, Auerbach and Hassett, 1991; Cummins, Hassett, and asset categories (for example, Auerbach and Hassett, 1991; Cummins, Hassett, and Hubbard, 1994; Hassett and Hubbard, 2002). These studies provide ample evidence Hubbard, 1994; Hassett and Hubbard, 2002). These studies provide ample evidence that changes in the user cost of capital—as fi rst defi ned by Dale Jorgenson as the that changes in the user cost of capital—as fi rst defi ned by Dale Jorgenson as the implicit rental cost of a capital investment that establishes its break-even marginal implicit rental cost of a capital investment that establishes its break-even marginal product—do infl uence the mix of investment, with the elasticity of equipment product—do infl uence the mix of investment, with the elasticity of equipment investment with respect to the user cost of capital falling in a range between –0.5 investment with respect to the user cost of capital falling in a range between –0.5 and –1.0. Using a related methodology, House and Shapiro (2008) estimate invest-and –1.0. Using a related methodology, House and Shapiro (2008) estimate invest- ment responses to the bonus depreciation incentives of 2002–2004, fi nding that the ment responses to the bonus depreciation incentives of 2002–2004, fi nding that the composition of investment did shift from nonqualifying investment to qualifying composition of investment did shift from nonqualifying investment to qualifying investment. One interesting result in the House–Shapiro analysis is that investment investment. One interesting result in the House–Shapiro analysis is that investment responses to the 2002 introduction of bonus depreciation appeared to begin during responses to the 2002 introduction of bonus depreciation appeared to begin during the last quarter of 2001 and the fi rst quarter of 2002, a period ultimately covered the last quarter of 2001 and the fi rst quarter of 2002, a period ultimately covered

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris 147

retroactively by the 2002 legislation. Thus, fi rms may have expected that investment retroactively by the 2002 legislation. Thus, fi rms may have expected that investment incentives would be enacted and that investment undertaken during this interval incentives would be enacted and that investment undertaken during this interval would be covered. This predictability of investment incentives should not be particu-would be covered. This predictability of investment incentives should not be particu- larly surprising, given how well one can predict their timing using a relatively simple larly surprising, given how well one can predict their timing using a relatively simple model (Auerbach and Gale, 2009a), but it can be a cause for concern, given that the model (Auerbach and Gale, 2009a), but it can be a cause for concern, given that the effect of announcing a new future investment incentive will tend to reduce current effect of announcing a new future investment incentive will tend to reduce current investment, at least if retroactive application of the incentive is not also anticipated. investment, at least if retroactive application of the incentive is not also anticipated.

In summary, tax incentives affect investment, with the compositional effects In summary, tax incentives affect investment, with the compositional effects more easily identifi ed than the aggregate effects. But relatively little attention more easily identifi ed than the aggregate effects. But relatively little attention has been given to the announcement effects of policy. Also, it is worth keeping in has been given to the announcement effects of policy. Also, it is worth keeping in mind that the conditions governing investment in a recession, such as cash-fl ow mind that the conditions governing investment in a recession, such as cash-fl ow constraints and business losses for tax purposes, may produce quite different invest-constraints and business losses for tax purposes, may produce quite different invest- ment responses to temporary tax cuts than would be predicted using models based ment responses to temporary tax cuts than would be predicted using models based on responses to long-term tax reforms adopted under more normal circumstances. on responses to long-term tax reforms adopted under more normal circumstances.

Besides cutting taxes or transferring funds to households and businesses, federal Besides cutting taxes or transferring funds to households and businesses, federal policy can also infl uence aggregate activity by altering state and local spending and policy can also infl uence aggregate activity by altering state and local spending and tax policy. This is, in principle at least, a potentially powerful avenue for stimulus, tax policy. This is, in principle at least, a potentially powerful avenue for stimulus, given the magnitude of state and local spending and taxes (more than 12 percent of given the magnitude of state and local spending and taxes (more than 12 percent of GDP in 2009) and the fact that almost all states have balanced budget rules. When GDP in 2009) and the fact that almost all states have balanced budget rules. When revenues fall during a recession, states can either draw down their “rainy day” funds, revenues fall during a recession, states can either draw down their “rainy day” funds, raise taxes, or cut spending—and the latter two options are likely to act as procy-raise taxes, or cut spending—and the latter two options are likely to act as procy- clical policies that could exacerbate the downturn. Poterba (1994), for example, clical policies that could exacerbate the downturn. Poterba (1994), for example, fi nds strong evidence that states contract spending and raise taxes when faced with fi nds strong evidence that states contract spending and raise taxes when faced with a negative fi scal shock. In such cases, federal transfers could ease the constraint and a negative fi scal shock. In such cases, federal transfers could ease the constraint and reduce the need for contractionary state responses.reduce the need for contractionary state responses.

While the argument for transfers to states being stimulative is plausible, there While the argument for transfers to states being stimulative is plausible, there is surprisingly little evidence on the countercyclical effects of federal transfers to is surprisingly little evidence on the countercyclical effects of federal transfers to states. Gramlich (1978, 1979) and Reischauer (1978) evaluate the effects of three states. Gramlich (1978, 1979) and Reischauer (1978) evaluate the effects of three federal grant programs undertaken in response to the 1974–75 recession. One federal grant programs undertaken in response to the 1974–75 recession. One program offered countercyclical revenues to the states in the form of block grants, program offered countercyclical revenues to the states in the form of block grants, another paid the salaries of state and local government workers, and a third contrib-another paid the salaries of state and local government workers, and a third contrib- uted funding for capital improvements. The general fi nding was that the short-run uted funding for capital improvements. The general fi nding was that the short-run response by states to federal aid was primarily to bolster state rainy-day funds, with response by states to federal aid was primarily to bolster state rainy-day funds, with only modest increases in outlays and reductions in taxes in the short run. The only modest increases in outlays and reductions in taxes in the short run. The long-run response—particularly in the form of decreased income tax revenue—long-run response—particularly in the form of decreased income tax revenue— was substantial, but materialized after the recession had ended. It is unclear how was substantial, but materialized after the recession had ended. It is unclear how relevant these fi ndings are to the current economic downturn, however, given the relevant these fi ndings are to the current economic downturn, however, given the dated nature of the evidence, the differences in the states’ economic situations dated nature of the evidence, the differences in the states’ economic situations now (when they have been hurt by both the recession and the housing crisis, now (when they have been hurt by both the recession and the housing crisis, which heightened the need for state transfers to local governments due to reduced which heightened the need for state transfers to local governments due to reduced municipal property tax revenues) and differences between the 1975 economy and municipal property tax revenues) and differences between the 1975 economy and the current one.the current one.

Although the effects of fi scal policy on individual components of output are of Although the effects of fi scal policy on individual components of output are of interest, and show the responsiveness of particular sectors to fi scal interventions, interest, and show the responsiveness of particular sectors to fi scal interventions,

148 Journal of Economic Perspectives

they do not capture the effects on overall output, since they omit the indirect, they do not capture the effects on overall output, since they omit the indirect, economywide responses.economywide responses.

Economywide EstimatesEconomywide Estimates Generally, three types of models have been used to examine the overall Generally, three types of models have been used to examine the overall

economic effects, with differing strengths and weaknesses: large-scale macroeco-economic effects, with differing strengths and weaknesses: large-scale macroeco- nomic models, structural vector autoregressions, and dynamic stochastic general nomic models, structural vector autoregressions, and dynamic stochastic general equilibrium models.equilibrium models.

Large-scale macroeconomic models account for relevant prices and quantities Large-scale macroeconomic models account for relevant prices and quantities in different sectors of the economy, and relate these prices and quantities to each in different sectors of the economy, and relate these prices and quantities to each other and to government policy variables. While large-scale models provide consid-other and to government policy variables. While large-scale models provide consid- erable detail regarding the channels through which policy can operate, and are erable detail regarding the channels through which policy can operate, and are commonly used by government forecasters, their theoretical grounding has been commonly used by government forecasters, their theoretical grounding has been challenged based on the argument that the structural equations describing the challenged based on the argument that the structural equations describing the behavior of households and fi rms lack adequate microfoundations (Lucas, 1976). behavior of households and fi rms lack adequate microfoundations (Lucas, 1976). Of the three types of models, large-scale macro models often produce the largest Of the three types of models, large-scale macro models often produce the largest multipliers. We discuss results from several large-scale models in subsequent sections multipliers. We discuss results from several large-scale models in subsequent sections when we address the effects of the American Recovery and Restoration Act of 2009. when we address the effects of the American Recovery and Restoration Act of 2009.

The two remaining types of models, which we now consider in turn, have been The two remaining types of models, which we now consider in turn, have been the mainstays of the recent academic literature. They represent alternative responses the mainstays of the recent academic literature. They represent alternative responses to the criticisms of large-scale models. One approach—dynamic stochastic general to the criticisms of large-scale models. One approach—dynamic stochastic general equilibrium (DSGE) models—hews more closely to micro-foundations; the other—equilibrium (DSGE) models—hews more closely to micro-foundations; the other— structural vector autogression (SVAR) models—moves away from attempts to establish structural vector autogression (SVAR) models—moves away from attempts to establish strong structural restrictions and relies to a greater extent on time series methods.strong structural restrictions and relies to a greater extent on time series methods.

In a standard vector autoregression, a vector of variables—say, output, taxes, In a standard vector autoregression, a vector of variables—say, output, taxes, and government purchases—is regressed on lagged values of the same variables. and government purchases—is regressed on lagged values of the same variables. Because there is no specifi cation of the channels through which policies affect Because there is no specifi cation of the channels through which policies affect output, it is not possible to separate the response of output to policy from the output, it is not possible to separate the response of output to policy from the response of policy to output. In a response of policy to output. In a structural vector autoregression, a limited structure vector autoregression, a limited structure is provided in the form of assumptions about the order in which shocks to policies is provided in the form of assumptions about the order in which shocks to policies and output occur (in more formal terms, assumptions about the recursive structure and output occur (in more formal terms, assumptions about the recursive structure of the error matrix). These assumptions make it possible to identify the changes in of the error matrix). These assumptions make it possible to identify the changes in current policy variables that are attributable to actual changes in policy rather than current policy variables that are attributable to actual changes in policy rather than to endogenous responses to economic conditions. The key issue in this literature is to endogenous responses to economic conditions. The key issue in this literature is the method used to identify “true” policy changes in attempting to obtain persua-the method used to identify “true” policy changes in attempting to obtain persua- sive multiplier estimates.sive multiplier estimates.

An important early contribution in the structural vector autoregression litera-An important early contribution in the structural vector autoregression litera- ture, by Blanchard and Perotti (2002), provides estimates of multipliers for both ture, by Blanchard and Perotti (2002), provides estimates of multipliers for both government purchases and taxes using the identifying assumption that these vari-government purchases and taxes using the identifying assumption that these vari- ables could respond to output within a quarter (the period of observation) only ables could respond to output within a quarter (the period of observation) only through automatic provisions, not discretionary policy. Thus, controlling for such through automatic provisions, not discretionary policy. Thus, controlling for such automatic response, which could be estimated directly, the fi scal shocks within a automatic response, which could be estimated directly, the fi scal shocks within a period could be treated as exogenous. Based on such a methodology, Blanchard period could be treated as exogenous. Based on such a methodology, Blanchard and Perotti estimate a GDP multiplier for government purchases of about 0.5 after and Perotti estimate a GDP multiplier for government purchases of about 0.5 after

Activist Fiscal Policy 149

one year, with longer-term multipliers depending on model specifi cation due to one year, with longer-term multipliers depending on model specifi cation due to differences in the estimated permanence of policies. That is, the short-term multi-differences in the estimated permanence of policies. That is, the short-term multi- pliers imply a net crowding-out of components of GDP other than the government pliers imply a net crowding-out of components of GDP other than the government purchases themselves. Estimates of tax cut multipliers are slightly larger, closer to purchases themselves. Estimates of tax cut multipliers are slightly larger, closer to 1.0 after one year.1.0 after one year.

As noted, a central concern with the structural vector autoregression approach As noted, a central concern with the structural vector autoregression approach is the identifi cation of policy shocks. A change in taxes or spending identifi ed by is the identifi cation of policy shocks. A change in taxes or spending identifi ed by the Blanchard and Perotti (2002) methodology as a policy shock might have been the Blanchard and Perotti (2002) methodology as a policy shock might have been anticipated by individuals (even if not by the econometric model) or it might not anticipated by individuals (even if not by the econometric model) or it might not have been a policy change at all (for example, it might be due to other factors have been a policy change at all (for example, it might be due to other factors such as a change in the income distribution). Thus, one line of research extending such as a change in the income distribution). Thus, one line of research extending this approach has been to identify policy changes through a narrative approach, this approach has been to identify policy changes through a narrative approach, applying additional information on policy decisions to help identify exogenous applying additional information on policy decisions to help identify exogenous policy changes, rather than treating as exogenous surprises those changes not policy changes, rather than treating as exogenous surprises those changes not predicted by the structural vector autoregression itself.predicted by the structural vector autoregression itself.

Using military spending build-ups as an important source of variation in Using military spending build-ups as an important source of variation in government purchases that is exogenous with respect to economic activity, Ramey government purchases that is exogenous with respect to economic activity, Ramey and Shapiro (1997) estimate the effect of these build-ups on GDP and its other and Shapiro (1997) estimate the effect of these build-ups on GDP and its other components. More recently, Ramey (2009) provides a more complete set of data on components. More recently, Ramey (2009) provides a more complete set of data on such shocks and emphasizes the importance of distinguishing the announcement such shocks and emphasizes the importance of distinguishing the announcement dates of policy changes from their dates of implementation. Using such a series dates of policy changes from their dates of implementation. Using such a series based on actual policy announcements, she estimates an output multiplier after based on actual policy announcements, she estimates an output multiplier after four quarters of about 0.7. As noted above, one implication of a multiplier below 1.0 four quarters of about 0.7. As noted above, one implication of a multiplier below 1.0 for government purchases is that other components of GDP fall in response to the for government purchases is that other components of GDP fall in response to the increase in government purchases.increase in government purchases.

On the tax side, the narrative approach to identifying policy shocks has been On the tax side, the narrative approach to identifying policy shocks has been introduced by Romer and Romer (2007), who used the same approach in earlier introduced by Romer and Romer (2007), who used the same approach in earlier analysis identifying monetary policy shocks. They argue that the multipliers of analysis identifying monetary policy shocks. They argue that the multipliers of tax changes estimated using other approaches are likely to underestimate tax tax changes estimated using other approaches are likely to underestimate tax policy multipliers by treating as exogenous many policy changes that were actually policy multipliers by treating as exogenous many policy changes that were actually responding to economic conditions or government purchases. Using their narra-responding to economic conditions or government purchases. Using their narra- tive approach to identify policy changes that were arguably independent of such tive approach to identify policy changes that were arguably independent of such other factors, they fi nd a GDP tax-cut multiplier of about 1.0 after four quarters, other factors, they fi nd a GDP tax-cut multiplier of about 1.0 after four quarters, rising to 3.0 after 10 quarters. This very large multiplier is associated with an enor-rising to 3.0 after 10 quarters. This very large multiplier is associated with an enor- mous impact on investment. The result is striking: indeed, so striking that it merits mous impact on investment. The result is striking: indeed, so striking that it merits further investigation.further investigation.44

Although the narrative approach may yield better estimates of true policy Although the narrative approach may yield better estimates of true policy surprises than the standard structural vector autoregression approach, both surprises than the standard structural vector autoregression approach, both approaches are limited in certain critical respects stemming from the reduced-form approaches are limited in certain critical respects stemming from the reduced-form

4 For example, Favero and Giavazzi (2009) suggest that the multipliers for the tax shocks identifi ed by Romer and Romer are considerably smaller if one models the shocks as explanatory variables in a multivariate model rather than simply regressing output on the tax shocks. The source of this difference is not clear, although the authors suggest that their results reject the assumptions by Romer and Romer that such shocks are independent of other explanatory variables.

150 Journal of Economic Perspectives

nature of these models. First, the models cannot be used to examine the economy’s nature of these models. First, the models cannot be used to examine the economy’s responses to automatic stabilizers or to any already-operating rules that relate responses to automatic stabilizers or to any already-operating rules that relate activist fi scal policy to economic conditions, because effects of both types are activist fi scal policy to economic conditions, because effects of both types are already incorporated in the model’s estimated impulse responses. Second, these already incorporated in the model’s estimated impulse responses. Second, these models can measure only the multipliers of policies that deviated from standard models can measure only the multipliers of policies that deviated from standard policy responses to economic conditions within the sample period and can only policy responses to economic conditions within the sample period and can only estimate the effects of those policies as they were actually adopted. For example, if estimate the effects of those policies as they were actually adopted. For example, if shocks to government purchases or taxes tended to be short-lived, then we cannot shocks to government purchases or taxes tended to be short-lived, then we cannot draw direct inferences about the effects of more permanent shocks. New tax draw direct inferences about the effects of more permanent shocks. New tax changes differing in composition from those examined in-sample could well have changes differing in composition from those examined in-sample could well have different multipliers than those estimated. This concern is especially important different multipliers than those estimated. This concern is especially important under the narrative approach, in the light of the fact that most of the estimates of under the narrative approach, in the light of the fact that most of the estimates of the effects of government purchases actually relate to defense spending and are the effects of government purchases actually relate to defense spending and are based heavily—almost exclusively—on the experience during World War II or the based heavily—almost exclusively—on the experience during World War II or the Korean War (Hall, 2009). Third, these models can only estimate the effects of policy Korean War (Hall, 2009). Third, these models can only estimate the effects of policy interventions under the economic conditions prevailing within the sample, and the interventions under the economic conditions prevailing within the sample, and the multiplier effects of different policies could vary substantially with economic condi-multiplier effects of different policies could vary substantially with economic condi- tions. Investment incentives that might be strong in a boom might be ineffectual tions. Investment incentives that might be strong in a boom might be ineffectual in a period of tight credit and net operating losses. Tax cuts for households might in a period of tight credit and net operating losses. Tax cuts for households might have a larger effect during periods in which liquidity constraints bind more tightly. have a larger effect during periods in which liquidity constraints bind more tightly. Government spending might have larger multipliers during periods, like recent Government spending might have larger multipliers during periods, like recent times, when the zero-interest-rate bound is binding.times, when the zero-interest-rate bound is binding.

As a consequence, much of the recent discussion and debate surrounding the As a consequence, much of the recent discussion and debate surrounding the potential effects of policy intervention have been based on the analysis of the third potential effects of policy intervention have been based on the analysis of the third approach alluded to above: dynamic stochastic general equilibrium models. These approach alluded to above: dynamic stochastic general equilibrium models. These models typically feature a relatively small number of equations based tightly on models typically feature a relatively small number of equations based tightly on microeconomic theory, with some parameters derived from empirical estimates and microeconomic theory, with some parameters derived from empirical estimates and others calibrated to make the model consistent with observed macroeconomic rela-others calibrated to make the model consistent with observed macroeconomic rela- tionships. Because these models specify a full economic structure, they can be used tionships. Because these models specify a full economic structure, they can be used to analyze policies and policy environments in a way that is not limited by historical to analyze policies and policy environments in a way that is not limited by historical experience. For example, they can explore interactions between monetary and experience. For example, they can explore interactions between monetary and fi scal policy, the role of long-term fi scal shortfalls on the effect of current stimulus fi scal policy, the role of long-term fi scal shortfalls on the effect of current stimulus packages, the role of different degrees of “openness” in the economy, the role of packages, the role of different degrees of “openness” in the economy, the role of anticipations of fi scal policy actions, and so on.anticipations of fi scal policy actions, and so on.

But to do these things, the dynamic stochastic general equilibrium approach But to do these things, the dynamic stochastic general equilibrium approach leans heavily on modeling assumptions that may or may not be valid: for example, leans heavily on modeling assumptions that may or may not be valid: for example, assumptions regarding the stickiness of wages and prices, the prevalence of assumptions regarding the stickiness of wages and prices, the prevalence of liquidity constraints, the rationality of agents, the structure of markets, and so liquidity constraints, the rationality of agents, the structure of markets, and so forth. Indeed, some of the recent disputes regarding the potential effects of fi scal forth. Indeed, some of the recent disputes regarding the potential effects of fi scal policies can be traced to differences in the assumptions in dynamic stochastic policies can be traced to differences in the assumptions in dynamic stochastic general equilibrium models as well as to assumptions about the nature and timing general equilibrium models as well as to assumptions about the nature and timing of the policies themselves.of the policies themselves.

In a recent review of the dynamic stochastic general equilibrium literature and In a recent review of the dynamic stochastic general equilibrium literature and using his own model of this type, Hall (2009) concludes that plausible dynamic using his own model of this type, Hall (2009) concludes that plausible dynamic

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris 151

stochastic general equilibrium models of the “new Keynesian” variety (that is, stochastic general equilibrium models of the “new Keynesian” variety (that is, incorporating certain nominal rigidities in wages and prices) generate govern-incorporating certain nominal rigidities in wages and prices) generate govern- ment spending multipliers that are consistent with those found using time series ment spending multipliers that are consistent with those found using time series methods—well above zero, but below 1.0. However, as Hall notes, it appears that methods—well above zero, but below 1.0. However, as Hall notes, it appears that in the dynamic stochastic general equilibrium approach, relatively small changes in the dynamic stochastic general equilibrium approach, relatively small changes in parameter specifi cation—within empirically plausible ranges—are capable of in parameter specifi cation—within empirically plausible ranges—are capable of producing substantial shifts in estimated multipliers. For example, several recent producing substantial shifts in estimated multipliers. For example, several recent analyses using dynamic stochastic general equilibrium models, notably papers by analyses using dynamic stochastic general equilibrium models, notably papers by Eggertsson (2008) and Christiano, Eichenbaum, and Rebelo (2009), have argued Eggertsson (2008) and Christiano, Eichenbaum, and Rebelo (2009), have argued that when nominal interest rates are close to zero, the government spending multi-that when nominal interest rates are close to zero, the government spending multi- plier can be substantially larger, with estimates in the range of 3 to 4.plier can be substantially larger, with estimates in the range of 3 to 4.55

One apparent explanation for the larger multiplier under the zero bound is One apparent explanation for the larger multiplier under the zero bound is that monetary policy responses are no longer active. The typical dynamic stochastic that monetary policy responses are no longer active. The typical dynamic stochastic general equilibrium model includes a Taylor (1993) rule for monetary policy: that general equilibrium model includes a Taylor (1993) rule for monetary policy: that is, a rule in which interest rates respond to the output gap and the infl ation rate. is, a rule in which interest rates respond to the output gap and the infl ation rate. In normal circumstances, a government spending increase would stimulate output In normal circumstances, a government spending increase would stimulate output and infl ation, which in turn would lead to an increase in interest rates, which would and infl ation, which in turn would lead to an increase in interest rates, which would reduce current consumption and investment demand. However, when nominal reduce current consumption and investment demand. However, when nominal interest rates fall to the zero bound, this response would be absent, and the output interest rates fall to the zero bound, this response would be absent, and the output response therefore would be larger, because the monetary authority would still wish response therefore would be larger, because the monetary authority would still wish for the nominal interest rate to be even lower.for the nominal interest rate to be even lower.

This intuition is apparently too simple, though, because some other dynamic This intuition is apparently too simple, though, because some other dynamic stochastic general equilibrium analyses assuming constant interest rates deliver stochastic general equilibrium analyses assuming constant interest rates deliver much smaller government spending multipliers. In particular, Cogan, Cwik, Taylor, much smaller government spending multipliers. In particular, Cogan, Cwik, Taylor, and Wieland (2009) estimate the response to a permanent increase in government and Wieland (2009) estimate the response to a permanent increase in government spending, assuming that interest rates stay equal to zero for the fi rst two years of spending, assuming that interest rates stay equal to zero for the fi rst two years of the experiment and follow a “Taylor rule” of reacting to unemployment and infl a-the experiment and follow a “Taylor rule” of reacting to unemployment and infl a- tion thereafter. They fi nd an original multiplier around 1, but that by the end of tion thereafter. They fi nd an original multiplier around 1, but that by the end of the two-year period, the effect on output is only 0.4. They attribute this difference the two-year period, the effect on output is only 0.4. They attribute this difference from papers fi nding larger multipliers to a shorter zero-bound period. This fi nding from papers fi nding larger multipliers to a shorter zero-bound period. This fi nding is consistent with the analysis presented by Woodford (2010) that multipliers are is consistent with the analysis presented by Woodford (2010) that multipliers are reduced to the extent that the increase in government spending extends beyond reduced to the extent that the increase in government spending extends beyond the end of the zero-bound period. Thus, the multiplier for government purchases the end of the zero-bound period. Thus, the multiplier for government purchases would be largest for a temporary spending increase that extended only for the would be largest for a temporary spending increase that extended only for the period in which the interest rate was near the zero lower bound.period in which the interest rate was near the zero lower bound.

Another factor that might infl uence fi scal multipliers is the government’s Another factor that might infl uence fi scal multipliers is the government’s long-term fi scal position. There are many reasons to think fi scal policies would long-term fi scal position. There are many reasons to think fi scal policies would have different effects if they are adopted during a period of fi scal stress than they have different effects if they are adopted during a period of fi scal stress than they would otherwise. An extensive theoretical and empirical literature argues that would otherwise. An extensive theoretical and empirical literature argues that

5 Although these models are more sophisticated, they echo the logic of simpler Keynesian models regarding the effectiveness of expansionary fi scal policy in a liquidity trap. Eggertsson (2008) also argues that a tax cut would be less expansionary in the zero-bound case, in fact having a negative effect on output, because its positive supply-side effects could have defl ationary consequences. But this conclusion would only apply to tax cuts that affected marginal tax rates.

152 Journal of Economic Perspectives

contractionary fi scal policy adopted during periods of budget stress can even have contractionary fi scal policy adopted during periods of budget stress can even have an expansionary effect on output, essentially by shifting the economy’s trajectory an expansionary effect on output, essentially by shifting the economy’s trajectory away from one that could be very constraining for productive activity because of high away from one that could be very constraining for productive activity because of high marginal tax rates or economic disruptions (Giavazzi and Pagano, 1990; Alesina and marginal tax rates or economic disruptions (Giavazzi and Pagano, 1990; Alesina and Ardagna, 1998; Alesina, Perotti, and Tavares, 1998). The empirical evidence, based Ardagna, 1998; Alesina, Perotti, and Tavares, 1998). The empirical evidence, based on panel data for OECD countries, does suggest that fi scal consolidation has a less-on panel data for OECD countries, does suggest that fi scal consolidation has a less- contractionary effect when adopted under fi scal stress, as measured by high debt contractionary effect when adopted under fi scal stress, as measured by high debt and projected government spending relative to GDP (Perotti, 1999). Analysis based and projected government spending relative to GDP (Perotti, 1999). Analysis based on OECD data also indicates that fi scal contractions are more expansionary when on OECD data also indicates that fi scal contractions are more expansionary when implemented through cuts in government spending, as one might expect given the implemented through cuts in government spending, as one might expect given the potential damage from reliance on higher marginal tax rates (Ardagna, 2004). One potential damage from reliance on higher marginal tax rates (Ardagna, 2004). One channel through which the differing effects of fi scal policy under different initial channel through which the differing effects of fi scal policy under different initial conditions may occur is through expectations of how the defi cit resulting from a conditions may occur is through expectations of how the defi cit resulting from a stimulus will be closed in the future. Several recent papers utilizing the dynamic stimulus will be closed in the future. Several recent papers utilizing the dynamic stochastic general equilibrium modeling approach address this issue with mixed stochastic general equilibrium modeling approach address this issue with mixed results (Corsetti, Meier, and Muller, 2009; Davig and Leeper, 2009; Leeper, Walker, results (Corsetti, Meier, and Muller, 2009; Davig and Leeper, 2009; Leeper, Walker, and Yang, 2009).and Yang, 2009).

In summary, while the different approaches used to model and analyze the direct In summary, while the different approaches used to model and analyze the direct and indirect effects of economic stimulus options have improved signifi cantly in and indirect effects of economic stimulus options have improved signifi cantly in recent years, the literature nevertheless shows a substantial amount of variation in key recent years, the literature nevertheless shows a substantial amount of variation in key results. Coenen et al. (2010) represents a noteworthy effort to systematize and under-results. Coenen et al. (2010) represents a noteworthy effort to systematize and under- stand these quantitative differences, using dynamic stochastic general equilibrium stand these quantitative differences, using dynamic stochastic general equilibrium models that are employed at the Federal Reserve Board, the European Commission, models that are employed at the Federal Reserve Board, the European Commission, the International Monetary Fund, the Bank of Canada, the European Central Bank, the International Monetary Fund, the Bank of Canada, the European Central Bank, and the OECD.and the OECD.

The American Recovery and Restoration Act of 2009The American Recovery and Restoration Act of 2009

The American Recovery and Restoration Act of 2009 (ARRA, Public Law 111-5) The American Recovery and Restoration Act of 2009 (ARRA, Public Law 111-5) can be viewed as the continuation of a series of activist fi scal policy interventions can be viewed as the continuation of a series of activist fi scal policy interventions dating back to 2001. But ARRA was of a different scale than previous efforts. The dating back to 2001. But ARRA was of a different scale than previous efforts. The direct cost of the bill (excluding interest payments on accumulated debt) was direct cost of the bill (excluding interest payments on accumulated debt) was originally estimated to be $787 billion over 10 years (Joint Committee on Taxation, originally estimated to be $787 billion over 10 years (Joint Committee on Taxation, 2009) and later revised to $862 billion (CBO, 2010).2009) and later revised to $862 billion (CBO, 2010).66 The policies were to be phased The policies were to be phased in over time, with $200 billion occurring in fi scal year 2009, $404 billion occurring in over time, with $200 billion occurring in fi scal year 2009, $404 billion occurring in fi scal year 2010, and the remainder occurring in fi scal year 2011 or afterwards.in fi scal year 2010, and the remainder occurring in fi scal year 2011 or afterwards.

Table 1 summarizes the major provisions of the bill and CBO’s (2009a) Table 1 summarizes the major provisions of the bill and CBO’s (2009a) range of estimates of the multipliers associated with each item. In broad terms, range of estimates of the multipliers associated with each item. In broad terms,

6 Most of the $75 billion increase in the estimated cost of the bill in CBO (2009a) was attributed to higher projected outlays, including an additional $21 billion for unemployment insurance, $34 billion more for the Supplemental Nutrition Assistance Program, and an extra $26 billion for the Build America Bond program; relatively small changes in the projected cost of other initiatives account for the remainder of the difference (CBO, 2010).

Activist Fiscal Policy 153

the provisions can be divided into tax cuts, assistance to states and individuals, and the provisions can be divided into tax cuts, assistance to states and individuals, and investments. The two largest tax cuts were the Making Work Pay Credit and the investments. The two largest tax cuts were the Making Work Pay Credit and the one-year extension of the higher Alternative Minimum Tax deduction. The Making one-year extension of the higher Alternative Minimum Tax deduction. The Making Work Pay Credit is a refundable tax credit of up to $400 per taxpayer ($800 for Work Pay Credit is a refundable tax credit of up to $400 per taxpayer ($800 for couples), equal to 6.2 percent of earned income for 2009 and 2010, with the value couples), equal to 6.2 percent of earned income for 2009 and 2010, with the value of the credit phasing-out for individuals with higher incomes. The stimulus package of the credit phasing-out for individuals with higher incomes. The stimulus package also expanded the eligibility criteria and raised the maximum value of the Earned also expanded the eligibility criteria and raised the maximum value of the Earned Income Tax Credit, expanded the refundability of the Child Tax Credit, and created Income Tax Credit, expanded the refundability of the Child Tax Credit, and created the American Opportunity Tax Credit—which replaced the Hope Credit and the American Opportunity Tax Credit—which replaced the Hope Credit and expanded tax incentives for higher education. Smaller provisions in the stimulus expanded tax incentives for higher education. Smaller provisions in the stimulus package included a revised tax credit for the purchase of a new home, suspension package included a revised tax credit for the purchase of a new home, suspension of the taxation of unemployment benefi ts, and a deduction for sales tax paid on the of the taxation of unemployment benefi ts, and a deduction for sales tax paid on the purchase of a new car.purchase of a new car.

Tax cuts for businesses were small relative to tax cuts for individuals, but include Tax cuts for businesses were small relative to tax cuts for individuals, but include an extension from two years to fi ve years in the amount of time that small businesses an extension from two years to fi ve years in the amount of time that small businesses

Table 1 Estimated Impact of the American Recovery and Reinvestment Act of 2009 on Output and the Budget, 2009–2019

Estimated policy multiplier 11-year budgetary cost of provisions

(billions of dollars)Category High Low  

Federal government purchases of goods and services

2.5 1.0 88

Transfers to state and local governments for infrastructure

2.5 1.0 44

Transfers to state and local governments not for infrastructure

1.9 0.7 215

Transfers to individuals 2.2 0.8 100

One-time payments to retirees 1.2 0.2 18

Two-year tax cuts for lower- and middle- income individuals

1.7 0.5 168

One-year tax cuts for higher-income individuals

0.5 0.1 70

Extension of fi rst-time homebuyer credit 1.0 0.2 7

Business tax provisions 0.4 0.0 21

Source: Congressional Budget Offi ce (2009a). Notes: As reported by the CBO, the policy multiplier is the cumulative impact on GDP over several quarters of various policy options. This table includes provisions scored by the CBO or the Joint Committee on Taxation as totaling $5 billion or more in budgetary costs over the 2009–2019 period. Selected provisions with lower total budgetary costs were included if the cost in the 2009–2011 period was large. Costs do not add up to the total budgetary cost of $787 billion presented in CBO’s cost estimate because several provisions are excluded (because CBO’s analysis of those provisions cannot easily be summarized by a single multiplier) and because the costs listed are translations of the budgetary costs to categories of the national income and product accounts.

154 Journal of Economic Perspectives

could “carry back” net operating losses to offset taxable income. The American could “carry back” net operating losses to offset taxable income. The American Recovery and Restoration Act also increased the amount of subsidized bonds that Recovery and Restoration Act also increased the amount of subsidized bonds that local governments can issue for private activity in economically-distressed areas. local governments can issue for private activity in economically-distressed areas. Altshuler et al. (2009) describe and evaluate the tax provisions contained in the Altshuler et al. (2009) describe and evaluate the tax provisions contained in the stimulus package.stimulus package.

A substantial portion of the American Recovery and Restoration Act provided A substantial portion of the American Recovery and Restoration Act provided aid to individuals and transfers to states, mainly through Medicaid and other aid to individuals and transfers to states, mainly through Medicaid and other programs administered by the Department of Health and Human Services, unem-programs administered by the Department of Health and Human Services, unem- ployment compensation, and food stamps. Transfers to the State Fiscal Stabilization ployment compensation, and food stamps. Transfers to the State Fiscal Stabilization Fund, a mechanism for providing education funding to states, were also signifi cant, Fund, a mechanism for providing education funding to states, were also signifi cant, as were one-time economic recovery payments to Social Security benefi ciaries, as were one-time economic recovery payments to Social Security benefi ciaries, veterans, and individuals receiving Supplemental Security Income.veterans, and individuals receiving Supplemental Security Income.

A primary objective of the stimulus package was to increase funding for public A primary objective of the stimulus package was to increase funding for public infrastructure programs. The major investments revolved around renewable energy, infrastructure programs. The major investments revolved around renewable energy, health care research, health information technology, subsidized infrastructure health care research, health information technology, subsidized infrastructure fi nancing, and education programs such as Pell Grants.fi nancing, and education programs such as Pell Grants.

Amounting to 5.5 percent of current-year GDP, albeit spread over several years, Amounting to 5.5 percent of current-year GDP, albeit spread over several years, the American Recovery and Restoration Act was the largest stimulus package in the American Recovery and Restoration Act was the largest stimulus package in modern U.S. economic history. Romer (2009) notes that the largest stimulus provi-modern U.S. economic history. Romer (2009) notes that the largest stimulus provi- sion during the Great Depression amounted to 1.5 percent of GDP and was followed sion during the Great Depression amounted to 1.5 percent of GDP and was followed one year later by defi cit reduction policies.one year later by defi cit reduction policies.

By way of comparison, almost all OECD countries have introduced stimulus By way of comparison, almost all OECD countries have introduced stimulus measures, with the packages averaging 2.5 percent of GDP. Automatic stabilizers, measures, with the packages averaging 2.5 percent of GDP. Automatic stabilizers, however, are substantially smaller in the United States than in most other OECD however, are substantially smaller in the United States than in most other OECD countries. As a result, while the United States had the largest discretionary stimulus countries. As a result, while the United States had the largest discretionary stimulus package, the combined effects of its automatic and discretionary policies on the package, the combined effects of its automatic and discretionary policies on the government’s budget for 2008–10 were the sixth largest as a share of GDP in the government’s budget for 2008–10 were the sixth largest as a share of GDP in the OECD (OECD, 2009).OECD (OECD, 2009).

Although the 2009 stimulus package was adopted during a period of very weak Although the 2009 stimulus package was adopted during a period of very weak economic performance, it encountered criticism on several fronts. The criticisms economic performance, it encountered criticism on several fronts. The criticisms can largely be summarized by asking whether the package was—in a phrase used by can largely be summarized by asking whether the package was—in a phrase used by Lawrence Summers (2007)—suffi ciently “timely, targeted, and temporary.”Lawrence Summers (2007)—suffi ciently “timely, targeted, and temporary.”

First, there was concern that the policies, although signed into law in February First, there was concern that the policies, although signed into law in February 2009, would be implemented only gradually, with much of the effect coming after 2009, would be implemented only gradually, with much of the effect coming after the recession was over and the recovery underway. Of course, this concern about the recession was over and the recovery underway. Of course, this concern about policy lags is one of the standard criticisms of countercyclical fi scal policy. However, policy lags is one of the standard criticisms of countercyclical fi scal policy. However, it seems somewhat less relevant in the present context, if projections of a long it seems somewhat less relevant in the present context, if projections of a long and slow recovery are to be believed. Figure 1 shows the path for GDP relative to and slow recovery are to be believed. Figure 1 shows the path for GDP relative to potential as projected in March 2009 by the Congressional Budget Offi ce, for the potential as projected in March 2009 by the Congressional Budget Offi ce, for the baseline without the February 2009 stimulus package and for two scenarios with baseline without the February 2009 stimulus package and for two scenarios with the fi scal package, corresponding to CBO’s perceived range of multiplier estimates the fi scal package, corresponding to CBO’s perceived range of multiplier estimates for the package’s different components. (These multipliers are detailed in Table for the package’s different components. (These multipliers are detailed in Table 1.) Under these projections, the economy would not reach its potential GDP until 1.) Under these projections, the economy would not reach its potential GDP until 2014, and the stimulus package—with three-quarters of its effects taking place in the 2014, and the stimulus package—with three-quarters of its effects taking place in the

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris 155

fi rst 18 months—would speed the rate of approach. Thus, while more rapid imple-fi rst 18 months—would speed the rate of approach. Thus, while more rapid imple- mentation might have been preferred, the biggest avoidable delay was probably at mentation might have been preferred, the biggest avoidable delay was probably at the enactment stage—that is, the time period late in 2008 in which a lame-duck the enactment stage—that is, the time period late in 2008 in which a lame-duck President Bush and the outgoing Congress deferred actions for months even after President Bush and the outgoing Congress deferred actions for months even after the likelihood of intervention became high. The risk of destabilizing the economy the likelihood of intervention became high. The risk of destabilizing the economy by injecting fi scal stimulus into an overheating economy seems to be less of an issue.by injecting fi scal stimulus into an overheating economy seems to be less of an issue.

The desire to keep the package temporary is motivated by concerns about The desire to keep the package temporary is motivated by concerns about the long-term budget outlook. However, the stimulus package contributed less to the long-term budget outlook. However, the stimulus package contributed less to the current-year defi cit than did the recession itself, through automatic stabilizers the current-year defi cit than did the recession itself, through automatic stabilizers working primarily on the tax side. As we have discussed elsewhere, the contribu-working primarily on the tax side. As we have discussed elsewhere, the contribu- tion of the stimulus package to the long-term U.S. fi scal problem is minimal, if one tion of the stimulus package to the long-term U.S. fi scal problem is minimal, if one assumes that the provisions of the stimulus are temporary as enacted (Auerbach and assumes that the provisions of the stimulus are temporary as enacted (Auerbach and Gale, 2009b).Gale, 2009b).

The inclusion in the stimulus package of a number of provisions designed orig-The inclusion in the stimulus package of a number of provisions designed orig- inally without the recession in mind—including some of the investments described inally without the recession in mind—including some of the investments described above—highlights the third set of concerns: that the package may not have been above—highlights the third set of concerns: that the package may not have been well-targeted to provide the strongest fi scal stimulus per dollar of revenue loss or well-targeted to provide the strongest fi scal stimulus per dollar of revenue loss or spending increase. Some critics focused on the composition of the package, ques-spending increase. Some critics focused on the composition of the package, ques- tioning whether projects that were “shovel-ready” were likely to be of high value tioning whether projects that were “shovel-ready” were likely to be of high value to society and whether the particular tax cuts adopted were the right ones from to society and whether the particular tax cuts adopted were the right ones from

Figure 1 Estimated Impact of 2009 Fiscal Stimulus

Source: Congressional Budget Offi ce (2009a). Note: Figure 1 shows the path for GDP relative to potential as projected in March 2009 by the Congressional Budget Offi ce for the baseline without the February 2009 stimulus package and for two scenarios with the fi scal package, corresponding to CBO’s perceived range of multiplier estimates for the package’s different components.

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–3

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156 Journal of Economic Perspectives

a longer-term perspective. While the stimulus package was certainly not as well-a longer-term perspective. While the stimulus package was certainly not as well- targeted as it could have been, there was some logic to its structure. As noted, the targeted as it could have been, there was some logic to its structure. As noted, the package contained substantial tax cuts, aid to states and individuals, and government package contained substantial tax cuts, aid to states and individuals, and government investments. The tax cuts should stimulate aggregate demand, but could have been investments. The tax cuts should stimulate aggregate demand, but could have been designed more effectively. The aid to individuals was based on humanitarian needs. designed more effectively. The aid to individuals was based on humanitarian needs. The aid to states was based on the notion, noted above, that because essentially all The aid to states was based on the notion, noted above, that because essentially all states adhere to some form of balanced-budget rule, economic declines that reduce states adhere to some form of balanced-budget rule, economic declines that reduce state revenues force cuts in state spending. From the perspective of macroeconomic state revenues force cuts in state spending. From the perspective of macroeconomic stabilization, reducing public spending during a sharp downturn is counterproduc-stabilization, reducing public spending during a sharp downturn is counterproduc- tive. The aid provided should offset some of the state and local spending cuts that tive. The aid provided should offset some of the state and local spending cuts that would otherwise have occurred. The fact that state and local government spending would otherwise have occurred. The fact that state and local government spending and employment rose in the second quarter of 2009 is consistent with the view and employment rose in the second quarter of 2009 is consistent with the view that the transfers supported and stabilized state budgets. In addition, because much that the transfers supported and stabilized state budgets. In addition, because much of the aid to states was based on criteria such as Medicaid eligibility—which is a of the aid to states was based on criteria such as Medicaid eligibility—which is a means-tested program—and state unemployment rates, the transfers to states were means-tested program—and state unemployment rates, the transfers to states were somewhat targeted to regions most in need of stimulus. Government investments somewhat targeted to regions most in need of stimulus. Government investments were part of a longer-term Obama administration agenda and are probably not best were part of a longer-term Obama administration agenda and are probably not best evaluated as stimulus measures.evaluated as stimulus measures.

How well-targeted the package was and the size of the resulting policy multi-How well-targeted the package was and the size of the resulting policy multi- pliers remain an area of controversy.pliers remain an area of controversy.77 Even before the stimulus package was adopted Even before the stimulus package was adopted in February 2009, the Obama administration released a document written by in February 2009, the Obama administration released a document written by Bernstein and Romer (2009) estimating the effect of a potential stimulus plan on Bernstein and Romer (2009) estimating the effect of a potential stimulus plan on employment. These projections were based on estimates of multipliers for govern-employment. These projections were based on estimates of multipliers for govern- ment purchases and tax cuts averaged over those from the Federal Reserve’s FRB/ment purchases and tax cuts averaged over those from the Federal Reserve’s FRB/ US model and a private forecasting model. The resulting multiplier for a permanent US model and a private forecasting model. The resulting multiplier for a permanent change in government purchases was about 1.5, reached after about one year; the change in government purchases was about 1.5, reached after about one year; the corresponding multiplier for tax cuts (other than investment incentives) was about corresponding multiplier for tax cuts (other than investment incentives) was about 1.0, with about three-fourths of the impact reached after one year and the full effect 1.0, with about three-fourths of the impact reached after one year and the full effect reached after two years. These multipliers are consistent with those assumed by the reached after two years. These multipliers are consistent with those assumed by the Congressional Budget Offi ce (2009a, Table 1) in making its projections, in that Congressional Budget Offi ce (2009a, Table 1) in making its projections, in that both the government-spending multiplier and the tax-cut multiplier fall roughly both the government-spending multiplier and the tax-cut multiplier fall roughly midway between the upper and lower bounds CBO lists for its high-multiplier and midway between the upper and lower bounds CBO lists for its high-multiplier and low-multiplier scenarios.low-multiplier scenarios.

The similarity in multiplier assumptions by the Council of Economic Advisers The similarity in multiplier assumptions by the Council of Economic Advisers and the Congressional Budget Offi ce is refl ected in similar estimates of the aggre-and the Congressional Budget Offi ce is refl ected in similar estimates of the aggre- gate impact of the stimulus package. The Congressional Budget Offi ce (2010) gate impact of the stimulus package. The Congressional Budget Offi ce (2010) estimates that, in the fi rst quarter of 2010, the stimulus package raised the level of estimates that, in the fi rst quarter of 2010, the stimulus package raised the level of GDP by between 1.7 percent and 4.2 percent and raised the level of employment by GDP by between 1.7 percent and 4.2 percent and raised the level of employment by 1.2 million to 2.8 million. The CEA (2010) recently estimated that, by the second 1.2 million to 2.8 million. The CEA (2010) recently estimated that, by the second

7 This controversy was highlighted by a Wall Street Journal article describing a poll of professional fore- casters. When asked about the net effect of the stimulus on economic growth and employment, 38 of the forecasters answered that ARRA had a positive effect, while six answered that the stimulus package had a negative effect (Izzo, 2010).

Activist Fiscal Policy 157

quarter of 2010, the package raised GDP by between 2.7 percent and 3.2 percent quarter of 2010, the package raised GDP by between 2.7 percent and 3.2 percent and raised employment by between 2.5 million and 3.6 million. A study by Blinder and raised employment by between 2.5 million and 3.6 million. A study by Blinder and Zandi (2010) using the Moody’s Analytics model of the U. S. economy esti-and Zandi (2010) using the Moody’s Analytics model of the U. S. economy esti- mates that the fi scal stimulus raised GDP by 3.4 percent in 2010, creating upwards mates that the fi scal stimulus raised GDP by 3.4 percent in 2010, creating upwards of 2.7 million jobs.of 2.7 million jobs.88 All of these studies are based on large-scale macroeconomic All of these studies are based on large-scale macroeconomic models, which incorporate traditional Keynesian features that can generate rela-models, which incorporate traditional Keynesian features that can generate rela- tively large multipliers when the economy is far from full employment, as was the tively large multipliers when the economy is far from full employment, as was the case in 2009. As discussed above, such multipliers are less easily generated using case in 2009. As discussed above, such multipliers are less easily generated using alternative modeling techniques, and this difference underlies the criticism of the alternative modeling techniques, and this difference underlies the criticism of the government studies by many economists outside of government (including Barro government studies by many economists outside of government (including Barro and Redlick, 2009; Cogan, Cwik, Taylor, and Wieland, 2009; and Leeper, Walker, and Redlick, 2009; Cogan, Cwik, Taylor, and Wieland, 2009; and Leeper, Walker, and Yang, 2009). For example, Cogan, Cwik, Taylor, and Wieland (2009) estimate and Yang, 2009). For example, Cogan, Cwik, Taylor, and Wieland (2009) estimate that, at its peak, the stimulus only raised GDP by 0.46 percent, resulting in an aggre-that, at its peak, the stimulus only raised GDP by 0.46 percent, resulting in an aggre- gate multiplier just over 0.6.gate multiplier just over 0.6.99

President Obama’s Council of Economic Advisers has offered two pieces of President Obama’s Council of Economic Advisers has offered two pieces of suggestive evidence drawn from recent experience that the higher levels of growth suggestive evidence drawn from recent experience that the higher levels of growth can reasonably be attributed to the American Recovery and Restoration Act. One can reasonably be attributed to the American Recovery and Restoration Act. One piece of evidence lies in the role of transfers to state and local governments. While piece of evidence lies in the role of transfers to state and local governments. While CEA doesn’t explicitly model the counterfactual baseline for state and local govern-CEA doesn’t explicitly model the counterfactual baseline for state and local govern- ment spending, the reports note that state and local government employment ment spending, the reports note that state and local government employment remained relatively stable during the second half of 2009, compared to the observed remained relatively stable during the second half of 2009, compared to the observed decline in several other sectors. Also, the CEA report cited the rapid acceleration in decline in several other sectors. Also, the CEA report cited the rapid acceleration in state and local government purchases in the second quarter of 2009, a situation that state and local government purchases in the second quarter of 2009, a situation that occurred despite ongoing fi scal crises in several state and local budgets.occurred despite ongoing fi scal crises in several state and local budgets.

The second piece of evidence involves measuring cross-country variation in The second piece of evidence involves measuring cross-country variation in stimulus legislation, and the subsequent changes in economic performance. Prasad stimulus legislation, and the subsequent changes in economic performance. Prasad and Sorkin (2009) describe various stimulus packages among G-20 countries in and Sorkin (2009) describe various stimulus packages among G-20 countries in 2009. Measured as a share of 2008 GDP, the stimulus package introduced in the 2009. Measured as a share of 2008 GDP, the stimulus package introduced in the United States—equal to 5.9 percent of GDP—was the second largest among G-20 United States—equal to 5.9 percent of GDP—was the second largest among G-20 countries; only Saudi Arabia devoted more spending to stimulating the economy. countries; only Saudi Arabia devoted more spending to stimulating the economy. Moreover, China and Spain were the only two other countries to enact stimulus Moreover, China and Spain were the only two other countries to enact stimulus packages in excess of 4 percent, although 10 countries implemented stimulus packages in excess of 4 percent, although 10 countries implemented stimulus packages in excess of 2 percent of GDP. CEA (2009b) fi nds that across countries, packages in excess of 2 percent of GDP. CEA (2009b) fi nds that across countries, large stimulus packages are correlated with more rapid economic growth in 2009. large stimulus packages are correlated with more rapid economic growth in 2009. The central fi nding in the CEA analysis is that economic growth is approximately The central fi nding in the CEA analysis is that economic growth is approximately 2 percentage points higher for every 1 percent of GDP in stimulus funding.2 percentage points higher for every 1 percent of GDP in stimulus funding.

8 Blinder and Zandi (2010) also provide what to our knowledge is the only estimate of the effects of all of the fi scal, monetary, and fi nancial interventions undertaken by the government over the past few years (including the Troubled Asset Relief Program and the Federal Reserve Board’s multifaceted policies). They estimate that in the absence of these programs, in 2010 GDP would be lower by 11.5 percent and employment would be lower by 8.5 million had the policies not been undertaken. 9 Even in cases where dynamic stochastic general equilibrium models can generate large multipliers, as discussed above, these results depend on the specifi c nature of the monetary policy mechanism when nominal interest rates are near zero, and do not generalize to all recessionary conditions.

158 Journal of Economic Perspectives

With these predictions and fi ndings in place, what can be said about the With these predictions and fi ndings in place, what can be said about the American Recovery and Restoration Act of 2009? If a fi scal stimulus were ever to American Recovery and Restoration Act of 2009? If a fi scal stimulus were ever to be considered appropriate, the beginning of 2009 was such a time. By the time the be considered appropriate, the beginning of 2009 was such a time. By the time the package was enacted, the U.S. economy was more than a year into the longest reces-package was enacted, the U.S. economy was more than a year into the longest reces- sion since the Great Depression, with several millions of jobs lost, nominal interest sion since the Great Depression, with several millions of jobs lost, nominal interest rates at zero, fears of defl ation, and no signs of life in the major components of rates at zero, fears of defl ation, and no signs of life in the major components of GDP. Moreover, much of the rest of the world was also in recession and thus not GDP. Moreover, much of the rest of the world was also in recession and thus not providing strong demand for U.S. exports. In these circumstances, our judgment is providing strong demand for U.S. exports. In these circumstances, our judgment is that a fi scal expansion carried much smaller risks than the lack of one would have. that a fi scal expansion carried much smaller risks than the lack of one would have. As to the structure of the package, its timing and its effects, there is more room for As to the structure of the package, its timing and its effects, there is more room for disagreement. One could argue that a large, diversifi ed, phased-in stimulus was the disagreement. One could argue that a large, diversifi ed, phased-in stimulus was the right approach: large because the economy was in dire straits, diversifi ed because right approach: large because the economy was in dire straits, diversifi ed because there is uncertainty about the size of the multipliers attached to different parts of the there is uncertainty about the size of the multipliers attached to different parts of the package, phased-in because it is hard to implement everything at once and there is package, phased-in because it is hard to implement everything at once and there is a long way to get back to full employment. But provisions could have been focused a long way to get back to full employment. But provisions could have been focused more effectively on options with high “bang for the buck,” and there remains consid-more effectively on options with high “bang for the buck,” and there remains consid- erable disagreement over the package’s ultimate effects on the economy.erable disagreement over the package’s ultimate effects on the economy.1010

Aside from the particular provisions of the act, though, there is a more general Aside from the particular provisions of the act, though, there is a more general manner in which the stimulus might have helped, although it is extremely hard to manner in which the stimulus might have helped, although it is extremely hard to quantify. Specifi cally, when the economy was in “free fall” in late 2008 and early quantify. Specifi cally, when the economy was in “free fall” in late 2008 and early 2009, the Obama administration and the Federal Reserve Board offered clear and 2009, the Obama administration and the Federal Reserve Board offered clear and strong statements that they would not stand by idly while the economy collapsed. strong statements that they would not stand by idly while the economy collapsed. This concerted and consistent display of intention may have shifted expectations This concerted and consistent display of intention may have shifted expectations among households and fi rms, giving them more confi dence to spend and invest among households and fi rms, giving them more confi dence to spend and invest than they otherwise would have.than they otherwise would have.1111

DiscussionDiscussion

In response to the recent, sharp downturn in economic activity, the U.S. federal In response to the recent, sharp downturn in economic activity, the U.S. federal government—and other governments around the world—enacted substantial government—and other governments around the world—enacted substantial fi scal stimulus packages. These policies continue a recent pattern of activist federal fi scal stimulus packages. These policies continue a recent pattern of activist federal fi scal interventions, at least in the United States, in which countercyclical fi scal fi scal interventions, at least in the United States, in which countercyclical fi scal policy has adjusted within a time frame that is relevant for stabilization purposes. policy has adjusted within a time frame that is relevant for stabilization purposes. There is robust evidence that well-designed tax cuts can boost consumption and There is robust evidence that well-designed tax cuts can boost consumption and investment in the short run, but models that examine the magnitude and timing of investment in the short run, but models that examine the magnitude and timing of

10 CBO (2009b) evaluated the impact of 11 stimulus policies on GDP growth, and found substantial variation among policy options. Several of the strategies identifi ed by CBO were included in the stimulus bills passed in 2008 and 2009. However, several of the high-impact options—such as reducing employers’ payroll taxes and aid to the unemployed—were either not included in the stimulus package or comprised a relatively small portion of the total cost. 11 Some consumer and business confi dence measures surged in the second quarter of 2009. For example, looking at data collected by the Conference Board, between the fi rst and second quarters of 2009, the CEO Confi dence Index increased from 30 to 50; between March 2009 and May 2009 the Consumer Confi dence Index rose from 26.9 to 54.8 and the Expectations Index increased from 30.2 to 71.5.

Alan J. Auerbach, William G. Gale, and Benjamin H. Harris 159

the indirect effects, taking into account economywide reactions, expectations, and the indirect effects, taking into account economywide reactions, expectations, and interactions provide a less-robust set of implications. Another potential source of interactions provide a less-robust set of implications. Another potential source of information is examination of the fi scal policy experience in the Great Depression information is examination of the fi scal policy experience in the Great Depression in the United States and the more recent “lost decade” in Japan. Unfortunately, in the United States and the more recent “lost decade” in Japan. Unfortunately, sustained fi scal policy expansion was not actually attempted in either episode, as sustained fi scal policy expansion was not actually attempted in either episode, as discussed more fully in Auerbach and Gale (2009a).discussed more fully in Auerbach and Gale (2009a).

Here, we highlight several issues that should play a critical role in future Here, we highlight several issues that should play a critical role in future research. The most critical task, of course, is understanding why multiplier esti-research. The most critical task, of course, is understanding why multiplier esti- mates vary so dramatically and designing research that can reduce the variation mates vary so dramatically and designing research that can reduce the variation in such estimates. This task is enormous: after all, it involves understanding the in such estimates. This task is enormous: after all, it involves understanding the structure of the entire economy. Nevertheless, it is remarkable that, 80 years after structure of the entire economy. Nevertheless, it is remarkable that, 80 years after the Great Depression and the onset of Keynesian economics, the range of main-the Great Depression and the onset of Keynesian economics, the range of main- stream estimates for multiplier effects is almost embarrassingly large. Several aspects stream estimates for multiplier effects is almost embarrassingly large. Several aspects of this challenge stand out. Multipliers will naturally depend on the state of the of this challenge stand out. Multipliers will naturally depend on the state of the economy, the state of fi nancial markets, and other public policies.economy, the state of fi nancial markets, and other public policies.1212 For example, For example, the recent downturn was caused by a fi nancial crisis and has hastened the onset of the recent downturn was caused by a fi nancial crisis and has hastened the onset of fi scal problems.  Understanding the role of fi scal multipliers in an environment fi scal problems.  Understanding the role of fi scal multipliers in an environment with dysfunctional fi nancial markets is a key challenge posed by this episode, as is with dysfunctional fi nancial markets is a key challenge posed by this episode, as is understanding the role of fi scal policy in the wake of a fi nancial crisis. In 2009, the understanding the role of fi scal policy in the wake of a fi nancial crisis. In 2009, the Federal Reserve extended more than $1 trillion worth of credit at the same time Federal Reserve extended more than $1 trillion worth of credit at the same time that the U.S. Treasury borrowed about $1.4 trillion, which highlights the poten-that the U.S. Treasury borrowed about $1.4 trillion, which highlights the poten- tially important interactions between monetary and fi scal policies. In addition, the tially important interactions between monetary and fi scal policies. In addition, the expansion of Federal Reserve policy beyond its traditional role of lending only to expansion of Federal Reserve policy beyond its traditional role of lending only to member banks to include new policies that indirectly helped to maintain lending to member banks to include new policies that indirectly helped to maintain lending to small businesses, students, and homeowners shows the fi ne line separating monetary small businesses, students, and homeowners shows the fi ne line separating monetary and fi scal policies, as previously existing federal programs already directly support and fi scal policies, as previously existing federal programs already directly support lending to those groups.lending to those groups.

A second area for research is the creative design of stimulus policies. Recent A second area for research is the creative design of stimulus policies. Recent advances in behavioral economics offer a wealth of policy levers beyond simple advances in behavioral economics offer a wealth of policy levers beyond simple income and substitution effects for encouraging people to change their behavior. income and substitution effects for encouraging people to change their behavior. For example, Epley, Mak, and Idson (2006) show how defi ning a tax cut as a For example, Epley, Mak, and Idson (2006) show how defi ning a tax cut as a “bonus” versus a “rebate” changes the way in which individuals recall how they “bonus” versus a “rebate” changes the way in which individuals recall how they spent the funds. Chambers and Spencer (2008) offer experimental evidence spent the funds. Chambers and Spencer (2008) offer experimental evidence on how the size and timing of a tax cut can affect the marginal propensity to on how the size and timing of a tax cut can affect the marginal propensity to consume. Chetty, Looney, and Kroft (2009) and Finkelstein (2009) show how the consume. Chetty, Looney, and Kroft (2009) and Finkelstein (2009) show how the consumption behavior is infl uenced by the salience of the tax. Congdon, Kling, consumption behavior is infl uenced by the salience of the tax. Congdon, Kling, and Mullainathan (2009) provide an overview of these issues as they apply to tax and Mullainathan (2009) provide an overview of these issues as they apply to tax policy. This literature suggests the role that creative design can play in designing policy. This literature suggests the role that creative design can play in designing more effective stimulus policies.more effective stimulus policies.

12 For one recent effort allowing multipliers to vary between recessions and expansions within the struc- tural vector autoregression framework, see Auerbach and Gorodnichenko (2010), who fi nd much larger government spending multipliers in recessions using postwar U.S. data.

160 Journal of Economic Perspectives

A related issue is the use of price incentives, rather than changes in after-tax A related issue is the use of price incentives, rather than changes in after-tax income, as a mechanism for providing stimulus. While price incentives in the form income, as a mechanism for providing stimulus. While price incentives in the form of investment tax credits and accelerated depreciation allowances have long been of investment tax credits and accelerated depreciation allowances have long been used to change fi rms’ behavior, they have a shorter history in encouraging consump-used to change fi rms’ behavior, they have a shorter history in encouraging consump- tion. “Cash for Clunkers” and the recent First-Time Homebuyer Credit illustrate tion. “Cash for Clunkers” and the recent First-Time Homebuyer Credit illustrate not just the potential, but also the problems with such programs: the homebuyers’ not just the potential, but also the problems with such programs: the homebuyers’ credit has been extended beyond its original deadline multiple times. As consumers credit has been extended beyond its original deadline multiple times. As consumers learn that such provisions may not be temporary, the effect on short-term spending learn that such provisions may not be temporary, the effect on short-term spending will diminish; and, as they learn to anticipate such policies, the policies may actually will diminish; and, as they learn to anticipate such policies, the policies may actually be destabilizing, as discussed above in relation to the use of bonus depreciation to be destabilizing, as discussed above in relation to the use of bonus depreciation to encourage business investment.encourage business investment.

An additional area for research is designing policy to balance short-term An additional area for research is designing policy to balance short-term stimulus and longer-term defi cit reduction. The United States and numerous other stimulus and longer-term defi cit reduction. The United States and numerous other countries face both weak current economies and looming long-term fi scal short-countries face both weak current economies and looming long-term fi scal short- falls. In the standard trade-off, cutting off fi scal stimulus too soon could plunge falls. In the standard trade-off, cutting off fi scal stimulus too soon could plunge the economy into a new downturn, as happened to the United States in 1937 and the economy into a new downturn, as happened to the United States in 1937 and Japan in 1997. However, letting stimulus run for too long could ignite investors’ Japan in 1997. However, letting stimulus run for too long could ignite investors’ fears and create the “hard landing” scenario discussed by Ball and Mankiw (1995) fears and create the “hard landing” scenario discussed by Ball and Mankiw (1995) and Rubin, Orszag, and Sinai (2004). Thus, it is worth noting that numerous coun-and Rubin, Orszag, and Sinai (2004). Thus, it is worth noting that numerous coun- tries have re-established fi scal discipline and created economic growth at the same tries have re-established fi scal discipline and created economic growth at the same time (IMF Fiscal Affairs Department, 2009). Indeed, between 1992 and 2000, the time (IMF Fiscal Affairs Department, 2009). Indeed, between 1992 and 2000, the United States improved its primary fi scal balance by 5.7 percent of GDP while also United States improved its primary fi scal balance by 5.7 percent of GDP while also exhibiting strong economic growth. Undoubtedly, a signifi cant share of U.S. growth exhibiting strong economic growth. Undoubtedly, a signifi cant share of U.S. growth in the 1990s was due to factors other than fi scal policy. Still, the notion that fi scal in the 1990s was due to factors other than fi scal policy. Still, the notion that fi scal strengthening and economic growth can move together is a point of optimism in strengthening and economic growth can move together is a point of optimism in the current situation.the current situation.

Activist fi scal interventions seem likely to play an enhanced role in policy Activist fi scal interventions seem likely to play an enhanced role in policy discussions and research activities in the future, given the last decade’s increase in discussions and research activities in the future, given the last decade’s increase in fi scal activism and continuing concerns about the state of the economy. Indeed, the fi scal activism and continuing concerns about the state of the economy. Indeed, the recent practice of fi scal policy has proceeded at a pace that has at times overtaken recent practice of fi scal policy has proceeded at a pace that has at times overtaken our understanding of its effects.our understanding of its effects.

■ The authors thank the editors, David Autor, Chad Jones, and Timothy Taylor, for extremely helpful remarks, and Ilana Fischer for research assistance.

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