President-elect Barack Obama's intention to blitz the economy with infrastructure spending will not be as effective as another option available to him: permanent, across-the-board tax cuts.
The president-elect has a great deal of history to instruct him here. Mr. Obama's hero, Franklin D. Roosevelt, tried to spend America out of the Great Depression with infrastructure projects, and they were a costly disappointment; unemployment averaged 17 percent during the height of the New Deal, from 1933 to 1940. Consider the Tennessee Valley Authority, one of FDR's most ambitious projects: In the decades since TVA dams began operating, states with TVA-subsidized electricity like Tennessee have lagged behind non-subsidized Southern states like Georgia in economic growth and average incomes.
There are at least three reasons why Mr. Obama's proposed spending spree probably won't stimulate the economy as hoped, and why permanent and aggressive tax cuts might.
First, "stimulus" spending is temporary, and, as such, has a very limited impact on people's spending habits. As Nobel laureate Milton Friedman explained, people generally base their spending habits on their anticipated stream of income - their regular paychecks. The one-time "stimulus" checks mailed out earlier this year had negligible impact on the economy. Public works projects are unlikely to do any better. And the money that government gives to some people comes from taxing other people, borrowing money (which must be repaid from future taxes) or inflating the currency (another kind of tax). People take this into account when making spending decisions.
Second, "stimulus" spending, particularly the kind of unprecedented program that Mr. Obama is calling for, tends to distort local spending priorities. For instance, Mr. Obama has suggested making money available to upgrade computers at schools. Schools will probably apply for computer-upgrade money rather than have it go someplace else, even if they don't need it and would spend any extra money differently.
Third, there is waste because people tend to be less careful with other people's money than they are with their own money. Members of Congress are so careless with other people's money that they often don't even read the spending bills they vote for. Every year, the U.S. Treasury reports "unreconciled transactions" - billions of dollars of expenditures with little to no documentation or explanation. Maryland, for instance, lost track of more than $80 million received from the federal government.
"Stimulus" spending is also likely to involve waste because government is a high-cost intermediary in transferring money from one group to another. Government overhead absorbs a hefty percentage of revenue collections so $1,000 of tax revenue doesn't mean $1,000 will be available for "stimulus" spending. This overhead includes 2.6 million federal employees, of which the Internal Revenue Service alone employs 100,000.
Why will tax cuts be more effective than stimulus spending?
Permanent, across-the-board tax cuts would probably do more than anything else to give employers, investors and consumers confidence that they could make plans for the future. Some of the most important rules of the game would become more predictable, not a subject of annual political scheming - a source of economic uncertainty and instability. That can only help the economy in the long run.
Tax cuts enable private individuals to make spending decisions about more of the money they earn, which would help spur recovery in several ways. Private individuals are likely to be more careful with their money than politicians. Private individuals stand to gain from good spending decisions and lose from bad spending decisions. By contrast, there seldom seems to be any effective consequences for politicians who squander other people's money - as the "unreconciled transactions" worth billions of dollars demonstrate.
Moreover, private individuals are more likely to be well-informed about their local circumstances than politicians in Washington. Private individuals know what is needed and what is effective, which is often very different from what politicians far away imagine. In addition, a tremendous amount of corruption would be avoided by keeping more money away from greedy, grasping politicians.
Discussion about economic stimulus tends to be dominated by the question of how much money will be spent, but the effectiveness of spending decisions is even more important. The United States was a comparatively poor country two hundred years ago, but it became wealthy because decisions about allocating resources were made mainly by private individuals with strong incentives to make the most of what they had. Similarly, in recent decades the expansion of private decision-making has enabled hundreds of millions throughout Asia to emerge from poverty. Cutting taxes returns resources to private individuals, who are best placed to make the most effective spending decisions.
Politicians would provide an effective stimulus by giving all of us an immediate and permanent pay raise - by letting us keep more of the money we earn now.