Cutting Taxes Better Stimulus than Government Spending

With all the push for more government spending (at both the state and federal level) to “stimulate the economy”, readers should take a look at new research highlighted by Greg Mankiw on the “multiplier effect” (related post by Tyler Cowen). 

The multiplier effect was the creation of John Maynard Keynes and his adherents who argued that government spending resulted in more economic growth because it multiplied.  That is, if the government spent $1 million to build a road, construction firms would then have $1 million to spend on other goods – likely spending only a percentage of that, say $800,000 on clothes.  The clothe-makers then spend that money on something else, and so on.  Keynesians argue that this works better than tax cuts (i.e. leaving money in the hands of consumers) because they will save some of it.

This theory has largely been discredited (discussed previously here and here) but remains en vogue among some, including the Rendell administration.  The new analysis pinpointed by Mankiw find that the spending multiplier is between one and 1.4 – i.e. a dollar spent by government increases GDP by one dollar.  However, another study finds that the multiplier effect for tax cuts is around 3.

Why is Keynes so wrong?  And why are tax cuts so much better?  Part of the reason is that “savings” (which Keynes believed undermined the multiplier effect) is actually good for the economy – in translates into investment, which translates into productions.  The other reason is that lower taxes provide incentives to be more productive, while higher taxes discourage wealth creation.

Mankiw Concludes:

My advise to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10. In particular, empirical studies that do not impose the restrictions of Keynesian theory suggest that you might get more bang for the buck with tax cuts than spending hikes.

I also tackled this issue in my latest commentary on “economic development spending” and economic growth.