Maybe Obama will turn out to be a Keynesian and a supply-sider. We know that the incoming President plans to boost the economy by spending big on infrastructure (Keynesianism) but maybe he’ll put faith in the tax cut gospel as well. Greg Mankiw points to a paper by Obama econ advisor Christina Romer (.pdf) suggesting that the multiplier effect on tax cuts is on the order of 3-1. Meanwhile the multiplier effect on government spending is somewhere around 1 to 1.4-1.
Why do tax cuts produce such a robust multiplier?
Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labour and, if labour and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit.
This hypothesized channel seems broadly consistent with the empirical findings of Blanchard and Perotti, Mountford and Uhlig, Alesina and Ardagna, and Alesina, Ardagna, Perotti, and Schiantarelli. The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy.
My advice to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognise that the world is vastly more complicated than the one we describe in ec 10.
That one of Obama’s key advisors has argued forcefully in favour of tax cuts is hopeful, since we think it would be suicidal to raise taxes in this economy. Besides, when you can raise money for free, deficit spending is the way to go.
The big hurdle to tax cuts, however, is the concept of fairness, which is an important issue for Obama and his supporters. Even with out a good macro argument for raising taxes, the idea that the wealth gap is too large motivates many of the interest groups that helped Obama win the election. But hopefully they’ll be aware that the situation has changed. The same investment vehicles that helped the wealthy build up outsized-returns over recent years — private equity funds and hedge funds — have been eviscerated. In addition to housing, finance has been obliterated. So if the goal is fairness or egalitarianism, hopefully Obama and his team appreciate the market is already pushing us towards that.