Christina Romer’s Study Found That Tax Cuts Work As An Economic Stimulus

Christina Romer

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Earlier this month, former Obama administration economic adviser Christina Romer delivered a lecture at Hamilton College in upstate New York in which claimed fiscal stimulus is effective.Romer’s claim about the effectiveness of fiscal policy is based on a study she did with her husband David Romer prior to her appointment as chair of Obama’s Council of Economic Advisors.  

They attempted to divide tax cuts implemented to ward off economic slumps from other types of tax cuts.

What they found when the ran the numbers is that tax cuts intended as anti-recessionary stimulus work. (Hat tip: The Money Illusion.)

This should be welcome by those of us who favour cutting taxes. But it is also being welcomed by the kind of people who think in terms of “aggregate demand” — which is to say, Keynesians of various stripes. For Keynesians, it is usually self-evident that if tax cuts work as stimulus, government spending will work even better.

The standard Keynesian logic on this is pretty simple. Some percentage of a tax cut will be saved by those who receive it. But all of government spending is actually spent, which means that it should have a greater stimulative effect.

Some Keynesians will even go so far as to say that even employing people to dig ditches and fill them back up will stimulate the economy. After all, that money is really being spent, put into the bank accounts of people who are actually made wealthier by the spending.

One problem with this point of view, however, is that the broader economy is not made any wealthier. If you dig ditches that don’t really need digging, you’ve provided cash to the jobless but not created any real assets of value. There’s nothing that can be bought or sold later. Or, even more important, nothing whose purchase can be foregone in the future because it was purchased now with government money.

To put it slightly differently, digging ditches and refilling them produce no carry-forward value. When the government spends on useless projects, it gets nothing in return. The next year it must spend to dig those same holes in the ground all over again.

Not all government spending is on worthless projects. But a far larger percentage of them are than is commonly conceived. Part of the problem is pure “waste, fraud and abuse” — the government spends too much of what it does acquire. So when the government builds a bridge, it gets the bridge but it is essentially paying for the bridge plus a bunch of useless ditches.

Tax cuts work very differently. A private household might decide to save a good portion of its tax cut. But every dollar it spends will go to satisfy a genuine economic need, rather than a political objective.

If you buy a Kindle Fire with 20 per cent of your savings from this year’s payroll tax cut, that’s a Kindle Fire you don’t have to buy next year.

On a technical economic level, you may have consumed $200. But that $200 of value doesn’t instantly vanish. You’ll still own the device next year and the year after that. You won’t have to keep spending $200 to get the same thing.

It shouldn’t be beyond an economist’s understanding that this matters in both the short term and the long term. If consumers believe government spending is wasteful, they’ll likely respond by realising the total wealth of the country is being diminished by the wasteful proportion of government spending. No future private-sector spending is offset by the amount of the waste.

How do consumers respond to this diminishing wealth through government waste? By saving for the future! So the economy contracts by the amount of expected government waste.

In other words, if the contractionary effect of wasteful government spending exceeds the savings following a tax cut, tax cuts will prove to be more stimulative than spending.

This post originally appeared at CNBC.