Tax cuts vs. Gov't spending

Some are claiming that it is not true that tax cuts have a bigger economic effect than does government spending. They argue that various studies show that a dollar of government spending has a bigger stimulus effect than does a dollar of tax cuts.

Problem is, those studies only consider the income effects of a tax cut (the extra money it puts in people's pockets), but without taking into account the incentive effects of lower tax rates. It's those incentive effects of lower rates that create additional economic activity (business start-ups, etc.), which results in growing wealth and employment down the road.

This is also why tax cuts, which reduce rates, are so much better than tax rebates, which just distribute checks. Those rebate checks may cause a brief bump in consumer demand, but they do nothing to alter the incentives to business expansion. A rate cut provides new incentives to risk a business start-up or expansion; a one-time mail-out of rebate checks has no such effect. Short-term stimulus spending is, in effect, nothing more than a huge pile of rebate checks -- except even less effective because government spending is more wasteful than spending by individuals.

In the end, the crucial difference here is, of course, political: Government spending enhances the scope and power of government, and Democrats value that above all. Like they say, elections have consequences.

Byron

For a discussion of these issues, see interview with Robert Barro:

Excerpt:

Interviewer: Why does this set of evidence depart from what seems like the standard Keynesian theory that a dollar of spending would have a larger multiplier than a dollar of tax cutting?

Barro: I don't think it is really confusing at all, because when you cut taxes there are two different effects. One is that you cut tax rates, and therefore give people incentives to do things like work and produce more and pay more -- maybe, depending on what kind of taxes. And then you also maybe give people more income. This income effect is the one that's related to this Keynesian multiplier argument, where it's usually argued that government spending should have a bigger effect. So that's the income effect. But the tax-rate effect, inducing people to do things like work and produce more and invest more, is a whole separate effect, and that could easily be much bigger than the multiplier thing, than the income thing.

Interviewer: This might just be my confusion, but the inducement to work, is separate from the idea of boosting aggregate demand and consumption in the short run.

Barro: Oh it's exceptionally different. But the experiment is that the government is doing something by changing the tax system to lower its collections -- by, for example, a tax cut. The response of the economy to that is not going just to isolate this business of giving people money. It's also going to have these incentive effects, more than tax rebates, on economic activity. It's going to be a combination of those two things -- income effects and incentive effects. One piece looks like this sort of multiplier stuff, which is analogous to government spending -- probably because the government spending has a first-round effect where it comes in and directly affects the aggregate demand -- and then in the second round it sort of looks like a tax cut. That's why the government spending thing is bigger in textbooks: because it has this first round in addition to all these subsequent ones.

But all that is just income responses -- people having more or less income, or the government keeping the money and then that shows up as people's income. None of that is about responses in terms of incentives -- incentives changing in response to lower or higher tax rates.