Economic Stimulus: Budget Policy for a Strong Economy Over the Short‐ and Long‐​Term

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Mr. Chairman, Members of the Committee, thank you for theopportunity to testify. My name is Dan Mitchell. I am a SeniorFellow at the Cato Institute. The views I'll be expressing todayare my own.

Government policy can have a large impact on economicperformance. With regards to fiscal policy in particular, theaggregate levels of taxation and spending matter. Relative changesin the aggregate levels of taxation and spending also influencegrowth.

Equally important, the composition of taxes and spending matter.Some types of taxation cause more economic damage, per dollarraised, than others because they lead to a bigger deadweight loss.There are similar differences on the spending side of the fiscalledger. Some types of spending are believed to enhance economicperformance by creating an environment that is conducive to work,saving, investment, risk-taking, and entrepreneurship. Other typesof spending are thought to hinder economic growth by, among otherthings, misallocating resources that could be used more efficientlyif left in the productive sector of the economy.

Economists do a poor job of predicting future economicperformance, and I have no desire to add to the profession'sembarrassment by offering my own guess about whether the economy isheading into a recession. For purposes of this testimony, though,let us assume that a downturn exists. Can fiscal policy help wardoff a downturn, or at least alleviate its impact?

The most realistic answer is no. While fiscal policy is veryimportant, as discussed above, it is much more likely to have animpact on long-run growth than it is to affect short-run economicperformance. And to the extent that fiscal policy can affectshort-run economic performance, it is because good long-term policyalso yields positive - albeit small - short-run results.

For all intents and purposes, today's stimulus debate is a newchapter in a long-running controversy about Keynesian economics.Based on the work of John Maynard Keynes, the theory asserts thatgovernment should borrow money and then inject it into an economy,causing additional consumer spending. Supposedly, this consumerspending means more demand for goods and services, which will causemore people to be employed to produce those goods and services.

There are several reasons to be skeptical about Keynesianstimulus. The key shortcoming is that it only looks at one-half ofthe equation. If the government sends a check to Person A, thatperson may run out and spend the money. And if the governmentspends money on Program B, that may result in an immediate outlay.But this type of analysis overlooks the fact that the governmentfirst has to borrow the money from Person C. In other words, anymoney in the pocket of Person A or any money spent on Program B isnecessarily offset by less money in the pocket of Person C. Thereis no increase in the amount of income in the economy - unless thegovernment monetizes the debt, and even that doesn't work sinceinflation simply reduces the value of existing money.

Some Keynesians admit that the money given to Person A or spenton Program B results in less money in the hands of Person C, butthey then argue that the goal is to transfer money from people whoare more likely to save and give it to people who are more likelyto consume. Indeed, this is why there often is a focus onredistributing the money to those with less income. In theory, poorpeople will rush out and spend the money right away.

Once again, though, the theory ignores the real-world economy.When Person C saves money, those funds don't disappear. Through theprocess of financial intermediation, the funds are allocated toborrowers. Those borrowers either use the money to purchaseconsumptions goods or investment goods. In other words, governmentborrowing to finance so-called stimulus programs merely "crowdsout" private sector borrowing and private sector spending. There isno increase in economy-wide spending.

To summarize, Keynesian stimulus plans do not work because theydo nothing to increase national income. All that happens is thatexisting national income gets redistributed from one person toanother. Another key point to understand is that consumer spendingis a consequence of economic growth, not the cause of economicgrowth.

There are a number of academic studies showing that Keynesianstimulus is not effective, but real-world examples are probablymore persuasive. There have been several episodes of Keynesian"pump priming," and there is little evidence that these attemptshave been successful. Beginning with the surge of deficit spendingduring the Great Depression, continuing through to the rebates ofthe 1970s, and most recently with the rebates of 2001, Keynesianstimulus packages have not succeeded.

The 2001 episode is particularly instructive. The bulk of the2001 tax cut - at least the part that took effect right away - wasKeynesian-style rebates and child credits. These provisions putmoney in people's pockets, but, as explained above, redistributingnational income is not the same as increasing national income. Assuch, the economy's growth was relatively anemic after the 2001 taxcut was adopted.

The 2003 tax cut, by contrast, was focused on "supply-side"provisions, including lower marginal tax rates on dividends, lowermarginal tax rates on capital gains, and - by accelerating theincome tax rate reductions scheduled for 2004 and 2006 - lowermarginal tax rates on work and entrepreneurship. It is nocoincidence that the economy performed much better after the 2003tax cut than it did after the 2001 tax cut. That's because the 2003tax rate reductions improved incentives to earn additional incomeby lowering tax rates on productive behavior.

To be sure, there are many factors that influence economicperformance, so it is always appropriate to use caution when tryingto interpret the impact of various policies. For instance, theeconomy's weakness during the 1930s presumably should not be blamedon the Keynesian policies. Expanding the size of government surelydid not help growth, but bad monetary policy, protectionism, hightax rates, and regulatory intervention all played a role inhindering a recovery.

Policies That Work

If Keynesian stimulus does not work, what other fiscal policyoptions are available? In part, the answer is that there are noautomatic fiscal policy solutions to an economic downturn -particularly when the economy's weakness is the result ofnon-fiscal factors such as poor monetary policy.

Good changes in fiscal policy help an economy grow faster, to besure, but the short-run effect is not very large. Imagine, forinstance, if the internal revenue code was replaced by a flat tax -much as nations ranging from Iceland to Mongolia have done.Moreover, imagine if that flat tax changes the economy's annualinflation-adjusted growth rate from 2.2 percent to 2.6 percent. Inthe short run, this does not have a big impact on living standards.Even after 10 years, the slight increase in the rate of annualgrowth does not translate into a big jump in national income.Indeed, it is only about 4 percent higher than it would havebeen.

But in the long run, the relatively small change in the rate ofgrowth has a big impact on living standards. Because ofcompounding, changes that seem trivial become very large. After 100years, an economy that grows 2.6 percent annually instead of 2.2percent annually will have about 50 percent more income.

The lesson of the story is that policy makers should concentrateon reforms that will improve the economy's long-run performance.With regards to fiscal policy, that means less government spending,not more government spending. That means permanently lower taxrates, not gimmicky temporary tax rebates.

Are Deficits Good or Bad?

For years, some people have been arguing that deficits areterrible because they supposedly boost interest rates, and thusreduce capital formation. This is the so-called Rubinomics schoolof thought, though 1950s-era Republicans made the same arguments.Now, many people - sometimes the same people - are saying we needhigher deficits to stimulate the economy.

So which is it? Are deficits good or bad? In reality, deficitsare the least important fiscal policy variable.

If budget surpluses were a path to economic nirvana, nationssuch as Sweden would be role models. Instead, largely because taxesand spending consume more than half of that nation's output, Swedeshave much lower living standards than Americans.

Likewise, if deficits were the key to prosperity, Japan shouldhave been an economic powerhouse after 1990. Deficits skyrocketedand debt exploded, often because of explicitly Keynesian stimulusprograms, but the economy remained mired in a long stagnation.

In third-world nations where debt is financed by printing money,deficits matter. In the United States, with a $14 trillion economyand government borrowing and debt at historically low levels,deficits qua deficits are largely irrelevant.

Deficits don't drive the economy. Indeed, it is the other wayaround. If the economy is strong, deficits tend to fall because taxrevenues rise and people are not clamoring for government programs.And if the economy is weak, deficits rise because taxpayers haveless taxable income and people are more likely to want money fromthe government.

In other words, what matters is the size of government and thestructure of the tax system. If government is too big, divertingtoo many resources from the productive sector, growth will suffer.If the tax system is too punitive, discouraging work, saving, andinvestment with high marginal tax rates, growth will suffer.Whether or not total spending is more than total revenue, orvice-versa, is a secondary issue.

Conclusion

To conclude, Keynesian economics is bad theory. It's even worsein practice. It didn't work in the 1930s, and it didn't work in the1970s. It didn't work earlier this decade. And it hasn't worked inother nations, such as Japan, that have tried to spend their way toprosperity. Thank you for this opportunity to testify. I will behappy to answer any questions.