I’m Confused

I just read paper The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks by Christina Romer and David Romer. It’s in the June 2010 issue of The American Economic Review (AER), the industry’s top peer-reviewed journal. Being in the AER is a guarantee that the paper is rigorous and insightful.

The paper is clear, and that’s not what I’m confused about. I’m confused because Christina Romer is one of the administration’s top economists, and the insights in her research are not being reflected in policy.

Romer and Romer find that there is a large negative tax multiplier, perhaps over three percent. That is for one percentage-point change in taxes as a percentage of GDP, you get an opposite three percent change in output, GDP. So, a one percentage point increase in taxes, as a percentage of GDP, results in a GDP decrease of about three percent. Conversely, a one percentage point decrease in taxes generates about three percent GDP growth.

The size of the tax multiplier stands in stark contrast with the best estimates of the spending multiplier. For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of 0.6 to 1.2.

The implication of the research is clear. Tax policy is a far more powerful economic stimulus tool than is spending policy. Why isn’t this research reflected in current policy?

Beats me.

Given the popular belief that economic conditions are important to a party’s reelection, ignoring this research appears to be irrational.

The Romers’ paper has other insights. One is that the purpose of the tax change seems to matter. Tax increases intended to reduce deficits are less harmful than a random tax increase. The authors speculate that part of this phenomenon is that tax increases to reduce deficits are usually accompanied by complementary spending cuts.

The most fascinating result is that the multiplier works mostly through investment. A tax increase has a small negative effect on consumption, but a large negative effect on investment. Similarly, a tax cut’s stimulative effect is mostly through investment and not consumption.

These findings have important implications for today. A lack of investment is a key characteristic of this business cycle. If we are in a recovery, this is why it will be so weak. Obviously, raising taxes would be the opposite of a stimulus, and best avoided for now. Instead, we need the mother of all investment tax credits.

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