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Choice of Policy

24 April, 2015 - 17:28

Suppose Congress and the president agree that something needs to be done to close a recessionary gap. We have learned that fiscal policies that increase government purchases, reduce taxes, or increase transfer payments—or do a combination of these—all have the potential, theoretically, to raise real GDP. The government must decide which kind of fiscal policy to employ. Because the decision makers who determine fiscal policy are all elected politicians, the choice among the policy options available is an intensely political matter, often reflecting the ideology of the politicians.

For example, those who believe that government is too big would argue for tax cuts to close recessionary g aps and for spending cuts to close inflationary gaps. Those who believe that the private sector has failed to provide adequately a host of services that would benefit society, such as better education or public transportation systems, tend to advocate increases in government purchases to close recessionary gaps and tax increases to close inflationary gaps.

Another area of contention comes from those who believe that fiscal policy should be constructed primarily so as to promote long-term growth. Supply-side economics is the school of thought that promotes the use of fiscal policy to stimulate long-run aggregate supply. Supply-side economists advocate reducing tax rates in order to encourage people to work more or more individuals to work and providing investment tax credits to stimulate capital formation.

While there is considerable debate over how strong the supply-side effects are in relation to the demand-side effects, such considerations may affect the choice of policies. Supply-siders tend to favor tax cuts over increases in government purchases or increases in transfer payments. President Reagan advocated tax cuts in 1981 on the basis of their supply-side effects. Coupled with increased defense spending in the early 1980s, fiscal policy under Mr. Reagan clearly stimulated aggregate demand by increasing both consumption and investment. Falling inflation and accelerated growth are signs that supply-side factors may also have been at work during that period. President George W. Bush’s chief economic adviser, N. Gregory Mankiw, argued that the Bush tax cuts would encourage economic growth, a supply-side argument. Mr. Bush’s next chief economic adviser, Ben Bernanke, who became the next chairman of the Federal Reserve Board in 2006, made a similar argument and urged that the Bush tax cuts be made permanent.

Finally, even when there is agreement to stimulate the economy, say through increasing government expenditures on highways, the how question remains. How should the expenditures be allocated? Specifically, which states should the highways run through? Each member of Congress has a political stake in the outcome. These types of considerations make the implementation lag particularly long for fiscal policy.

KEY TAKEAWAYS

  • Discretionary fiscal policy involves the same kind of lags as monetary policy. However, the implementation lag in fiscal policy is likely to be more pronounced, while the impact lag is likely to be less pronounced.
  • Expansionary fiscal policy may result in the crowding out of private investment and net exports, reducing the impact of the policy. Similarly, contractionary policy may “crowd in” additional investment and net exports, reducing the contractionary impact of the policy.
  • Supply-side economics stresses the use of fiscal policy to stimulate economic growth. Advocates of supply-side economics generally favor tax cuts to stimulate economic growth.

TRY IT!

Do the following hypothetical situations tend to enhance or make more difficult the use of fiscal policy as a stabilization tool?

  1. Better and more speedily available data on the state of the economy
  2. A finding that private sector investment spending is not much affected by interest rate changes
  3. A finding that the supply-side effects of a tax cut are substantial

Case in Point: Crowding Out in Canada

In an intriguing study, economist Baotai Wang examined the degree of crowding out of Canadian private investment as a result of government expenditures from 1961–2000. What made Professor Wang’s analysis unusual was that he divided Canadian government expenditures into five categories: expenditures for health and education, expenditures for capital and infrastructure, expenditures for the protection of persons and property (which included defense spending), expenditures for debt services, and expenditures for government and social services.

Mr. Wang found that only government expenditures for capital and infrastructure crowded out private investment. While these expenditures reduced private investment, they represented increased public sector investment for things such as highways and ports.

Expenditures for health and education actually “crowded in” private sector investment. These expenditures, Mr. Wang argued, represented increases in human capital. Such increases complement returns on private sector investment and therefore increase it.

Mr. Wang found that Canadian government expenditures for debt service, the protection of persons and property, and for government and social services had no effect on private sector investment. He argued that expenditures for protection of persons and property may involve some crowding out, but that they also stimulated private investment by firms winning government contracts for defense purchases. The same explanation could be applied to government expenditures for government and social services. These also include an element of investment in human capital.

His results suggest that crowding out depends on the nature of spending done by the government. Some kinds of spending clearly did not crowd out private sector investment in Canada.

Source: Baotai Wang, “Effects of Government Expenditure on Private Investment: Canadian Empirical Evidence,” Empirical Economics 30, no. 2

ANSWERS TO TRY IT! PROBLEMS

  1. Data on the economy that are more accurate and more speedily available should enhance the use of fiscal policy by reducing the length of the recognition lag.
  2. If private sector investment does not respond much to interest rate changes, then there will be less crowding out when expansionary policies are undertaken. That is, the rising interest rates that accompany expansionary fiscal policy will not reduce investment spending much, making the shift in the aggregate demand curve to the right greater than it would be otherwise. Also, the use of contractionary fiscal policy would be more effective, since the fall in interest rates would “invite in” less investment spending, making the shift in the aggregate demand curve to the left greater than it would otherwise be.
  3. Large supply-side effects enhance the impact of tax cuts. For a given expansionary policy, without the supply-side effects, GDP would advance only to the point where the aggregate demand curve intersects the short-run aggregate supply curve. With the supply-side effects, both the short-run and long-run aggregate supply curves shift to the right. The intersection of the AD curve with the now increased short run aggregate supply curve will be farther to the right than it would have been in the absence of the supply-side effects. The potential level of real GDP will also increase.