Better cut taxes than increase government spending

Gregory Mankiw, professor of economics at Harvard, wrote an interesting article for New York Times, where he argues for using tax cuts instead of increasing government spending as a tool of economic stimulus. Here’s the evidence:

1) Obama’s Fiscal Stimulus failed

When President Obama was elected, the economy was sick and getting sicker. Before he was even in office in January, his economic team released a report on the problem.

If nothing was done, the report said, the unemployment rate would keep rising, reaching 9 percent in early 2010. But if the nation embarked on a fiscal stimulus of $775 billion, mainly in the form of increased government spending, the unemployment rate was predicted to stay under 8 percent.

In fact, the Congress passed a sizable fiscal stimulus. Yet things turned out worse than the White House expected. The unemployment rate is now 10 percent — a full percentage point above what the administration economists said would occur without any stimulus.

2) Nothing better than tax cuts

When devising its fiscal package, the Obama administration relied on conventional economic models based in part on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy.

The report in January put numbers to this conclusion. It says that an extra dollar of government spending raises G.D.P. by $1.57, while a dollar of tax cuts raises G.D.P. by only 99 cents. The implication is that if we are going to increase the budget deficit to promote growth and jobs, it is better to spend more than tax less.

But various recent studies suggest that conventional wisdom is backward.

One piece of evidence comes from Christina D. Romer, the chairwoman of the president’s Council of Economic Advisers. In work with her husband, David H. Romer, written at the University of California, Berkeley, just months before she took her current job, Ms. Romer found that tax policy has a powerful influence on economic activity.

According to the Romers, each dollar of tax cuts has historically raised G.D.P. by about $3 — three times the figure used in the administration report. That is also far greater than most estimates of the effects of government spending.

3) Economists say:

Other recent work supports the Romers’ findings. In a December 2008 working paper, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago apply state-of-the-art statistical tools to United States data to compare the effects of deficit-financed spending, deficit-financed tax cuts and tax-financed spending. They report that “deficit-financed tax cuts work best among these three scenarios to improve G.D.P.”

My Harvard colleagues Alberto Alesina and Silvia Ardagna have recently conducted a comprehensive analysis of the issue. In an October study, they looked at large changes in fiscal policy in 21 nations in the Organization for Economic Cooperation and Development. They identified 91 episodes since 1970 in which policy moved to stimulate the economy. They then compared the policy interventions that succeeded — that is, those that were actually followed by robust growth — with those that failed.

The results are striking. Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending.