The school of thinking known as Keynesian economics holds that government should actively and aggressively manage the economy, most importantly by stepping up spending when demand is low. Through this deficit spending, it is said that government action can increase employment. This government spending purportedly accomplishes this through a multiplier effect, as dollars are spent again and again.
The value of the spending multiplier — is it big or small? — is an important question. Also, the multiplier effect may be different for government spending versus private spending.
Now, we’re starting to understand why Keynesian economics doesn’t work. Writing in the Wall Street Journal, Stanford economist Michael J. Boskin summarizes recent research that finds that the spending multiplier is small, and actually turns negative by the start of the second year. Furthermore, the government spending crowds out private sector spending. The effect of Obama’s 2009 stimulus bill is estimated at 0.2 percent of GDP, an amount described as “puny.”
Tax cuts, however, are estimated to have a multiplier of 3.0, with “substantial tax cuts” having a multiplier of up to 5.0.
In context, Obama’s economic advisers, at the time he took office, estimated that the spending multiplier for government purchases was 1.57, while the multiplier for tax cuts was 0.99.
Of the new studies finding a small spending multiplier, Boskin writes: “These empirical studies leave many leading economists dubious about the ability of government spending to boost the economy in the short run. Worse, the large long-term costs of debt-financed spending are ignored in most studies of short-run fiscal stimulus and even more so in the political debate.”
In conclusion, he writes: “The complexity of a dynamic market economy is not easily captured even by sophisticated modeling (an idea stressed by Friedrich Hayek and Robert Solow). But based on the best economic evidence, we should reject increased spending and increased taxes.” He calls for reductions in personal and corporate marginal tax rates and an “enforceable gradual phase-down of the spending explosion of recent years.”
We should note that Obama and many of those in government are easily seduced by the allure of Keynesian deficit spending. It’s government, after all, that gets to spend the money. Republicans, even those who consider themselves conservative, have been seduced in this way, too.
Tax cuts, on the other hand, leave money and spending decisions in the private sector.
Why the Spending Stimulus Failed
New economic research shows why lower tax rates do far more to spur growth.
By Michael J. Boskin
President Obama and congressional leaders meeting yesterday confronted calls for four key fiscal decisions: short-run fiscal stimulus, medium-term fiscal consolidation, and long-run tax and entitlement reform. Mr. Obama wants more spending, especially on infrastructure, and higher tax rates on income, capital gains and dividends (by allowing the lower Bush rates to expire). The intellectual and political left argues that the failed $814 billion stimulus in 2009 wasn’t big enough, and that spending control any time soon will derail the economy.
But economic theory, history and statistical studies reveal that more taxes and spending are more likely to harm than help the economy. Those who demand spending control and oppose tax hikes hold the intellectual high ground.
Continue reading at the Wall Street Journal (subscription not required)