Thinking Clearly About Stimulus Spending

Click here for a printer-friendly version of this article

With just a few weeks left before Congress breaks for the August recess, stimulus spending remains at the forefront of the national debate. Additional “stimulus” spending in the form of extended unemployment benefits will be the first measure considered by the Senate this week, but further fights loom over new spending for states and education programs – many of which have been attached to the an emergency war supplemental bill that’s considered “must-pass” before recess. The House supports the new spending, many in the Senate stand in opposition, and the White House has even murmured a veto threat over one of the proposed offsets. As the debate over what could and should constitute stimulus (and when it should end) rolls on, some clear thinking about the real effects of the stimulus are in order.

Many advocates of additional fiscal stimulus have recently expressed dismay that rising public concerns about the deficit have gotten in the way of the next round of hoped-for federal spending. One prominent columnist expressed horror that a growing consensus for “immediate fiscal austerity” (based on “figments of the policy elite’s imagination”) would derail economic recovery. Another stimulus advocate lamented that “I do not understand how, or why we have lost the argument” for still more government spending.

Yet another columnist described a purported divide within the White House between wise economists who understood the need for more stimulus, and political communications staff who wanted to cater to misguided public concerns about the deficit. Fear not, the column assured us, for there is an easy answer: another round of stimulus spending is not only good governance but good politics – because, after all, the more the federal government spends, the better off economically this November’s electorate will be.

We at e21 do not pretend to know the optimal balance between near-term stimulus spending and long-term fiscal restraint, in an environment simultaneously characterized by near-term economic weakness and unsustainable long-term deficits. But to help guide policy makers in thinking through stimulus-related issues, we offer the following points to bear in mind.

First: To determine whether there should be more or less federal fiscal stimulus, we need to know how much there already is. The short answer: a lot. Indeed, a non-world-war record. Below are the ten highest years for federal deficits (since 1930, the earliest recorded) as a percentage of GDP, according to OMB:

The current total level of federal fiscal stimulus exceeds that at any other point in U.S. history excepting the years of World War II, and dwarfs the amount engaged in by the Roosevelt Administration during the Great Depression. In fact, OMB’s projected 2010 deficit, as a % of GDP, is greater than the total amount of federal spending in 9 of the 10 years of the 1930s.

Is this fiscal stimulus being provided primarily in the form of spending, or of tax relief? Let’s look at the ten highest years for federal spending as a percentage of GDP.

Far from succumbing to entreaties for immediate fiscal austerity, the federal government is currently spending at a rate faster even than the year after Pearl Harbor. Of the top ten federal spending years in American history, it is already projected that four will be the four years of President Obama’s current term.

Second, stimulus spending doesn’t pay for itself. This might seem like an obvious point, but with all the talk in the press about “multipliers” (the amount of additional GDP reportedly generated by every $1 of stimulus spending), one could easily get the misimpression that stimulus spending itself creates enough additional economic growth to improve the federal fiscal outlook.

It doesn’t. Even if one accepts CBO’s optimistic take that many forms of stimulus spending result in more than $1 added to GDP for every $1 spent, the additional revenue generated for the federal government would be significantly less, leaving the vast majority of stimulus costs to be added to the deficit.

Opponents of tax relief are fond of pointing out that tax relief “doesn’t pay for itself” on the federal ledger. Neither, of course, does stimulus spending.

Third, stimulus spending doesn’t create permanent growth from nothing. If policy decisions were so simple a matter as permanently increasing GDP via federal stimulus, then politicians would have a very easy time of it. There would be limitless spending increases enacted to please Democrats and tax cuts to please Republicans. Both parties would simply enjoy the fruits of having delivered popular measures while adding painlessly to the prosperity of the American people.

In reality, stimulus decisions involve more complicated trade-offs. Stimulus spending can increase GDP growth, but mounting federal deficits retard long-term growth. If a business is induced via a temporary tax break to buy equipment this year that they otherwise would have bought next year, that increases this year’s GDP output but subtracts from next year’s. Similarly, a house bought today to take advantage of a tax credit is more likely to replace a future purchase than to add to it. Federal policy makers don’t have the luxury of adding unambiguously to the US economic output – rather, they instead face the more difficult decision of how much to add to this year’s output while likely subtracting from a future year’s.

Fourth, even optimistic analyses of stimulus effects suggest that it would require enormous additional deficit spending to effect a qualitative change in the employment environment. The Congressional Budget Office has estimated that the stimulus package lowered the unemployment rate by 0.7%-1.5% relative to what it otherwise would have been – at a cost of $862 billion, plus interest. Assuming a median value of a 1.1 point difference in the unemployment rate for a package of that size, this means that a further half-trillion in deficit spending would do well even to move unemployment rates below 9.0%.

In short, workers will still have a rough time of it even if we render the federal budget still less tenable than it already is.

Fifth, passing a stimulus package typically requires a large surcharge in the form of non-stimulus spending. Government officials are well familiar with the “chalkboard fallacy” – the tendency of those outside the government to recommend policies without accounting for how they will inevitably be distorted in the political process. In the past, Congress has shown itself unwilling to enact stimulus spending bills without combining with additional deficit spending well after the period of so-called “stimulus” – provisions that add to long-term deficits without facilitating near-term growth.

The $862 billion stimulus package of 2009, for example, contained $604 billion in stimulus spending over 2009-2010, combined with a further $258 billion from 2011-2019. In other words, in order to receive $604 billion in additional federal fiscal stimulus over 2009-2010, taxpayers will face a surcharge of 43% – to be financed, plus interest, from 2011 onward – for spending wholly unrelated to strengthening the economy today.

It is often noted that one argument for near-term stimulus is that the federal government is able to borrow cheaply during a slow-growth period, which enables it to bolster the economy today with minimal damage to its long-term finances. This neglects the political realities of stimulus legislation, which has consistently been delivered with additional costs far beyond those associated with near-term stimulus. In practical effect, the “interest cost” of federal stimulus legislation is quite high.

Sixth and finally, by far the biggest threat of near-term fiscal austerity comes not from plans to slash federal spending but from the pending expiration of current tax rates. Those worrying about fiscal austerity are correct in one respect – there actually is a near-term threat that federal policy will have a contractive effect upon the economy. It’s the threat of a massive tax increase.

According to CBO, if current tax rates are allowed to expire, individual income tax payments as a percentage of GDP will increase by over one-quarter (from 6.5% to 8.4%) from 2010 to 2011. Corporate tax payments would rise by roughly 80% as a share of GDP (from 1.0% to 1.8%). Under current law, virtually the entirety of any “austerity” effects threatened in 2011 would be on the tax side.

Some of this expected increase is attributable to projected economic recovery, but there is no escaping the reality that hanging over the economy is a threat that tax burdens will be permitted to rise by 2012 well above their historic averages, and continue to mount after that. If we are seriously worried about a “lost decade,” levying such huge tax burdens amid an uncertain recovery seems particularly unwise.

This by itself does not necessarily argue for the extension of all current tax policies permanently. But the fact is inescapable that contractionary federal economic policy is more likely to arrive in the form of new taxes than as sudden reductions in government spending.

There is no easy answer to the question of how much stimulus spending the federal government should engage in when faced with a troubled economy. But policy makers would do well to remember that federal spending and deficits are already at historic levels, and that even these current “stimulus” policies will exact a heavy long-term cost.