Spending is a more effective form of stimulus than tax cuts. So explains Paul Krugman in an Econ 101 style.
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Paul Krugman - New York Times Blog
January 31, 2009, 6:37 pm
Another temporary misunderstanding
Brad DeLong links to Megan McArdle saying something wrong about the effects of a temporary increase in government spending. But he fails to note that it’s not just wrong, it’s 180 degrees wrong: a temporary increase in government spending should have a larger impact on demand than a permanent increase, not a smaller impact.
And that’s actually an important point: one way to explain why government spending is better than tax cuts as a stimulus is to say that temporary tax cuts aren’t effective at increasing demand, but temporary spending increases are.
Here’s the logic (which follows directly from Milton Friedman’s permanent income hypothesis, by the way): suppose that the government introduces a new program that will cause it to spend $100 billion a year every year from now on. To pay for this, it will have to raise taxes by $100 billion a year, permanently — and if consumers take this into account, they might well cut their spending enough to offset the increase in government purchases.
But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say, $5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)
So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts.
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