David R. Henderson  

Budget Cuts Seem to Work

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Washington Post blogger Mike Konzcal writes that we now have a test of monetary vs. fiscal policy. According to him, fiscal policy won. That is, fiscal policy is more potent and monetary policy is impotent. In fact the very data he cites show the opposite.

Here's his key paragraph:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It's still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

And what did the GDP report say? Konzcal links to fellow WaPost blogger Neil Irwin's post about the GDP report. Irwin writes:
We're still stuck in the muck.
That's the conclusion to draw from the new report on gross domestic product. The U.S. economy grew at a 2.5 percent annual rate in the first three months of the year, which was an improvement from the weak 0.4 percent of the final months of 2012. But Friday's report was nearly a percentage point below analysts' expectations, and for the last six months, number averages to only a 1.45 percent annual rate of growth.

Hmmm. What happened in the first quarter of this year, the quarter in which growth rose? Oh, yes, we had cuts in government spending. Irwin writes:
Indeed, the biggest culprit in the weak report was the government sector, which fell at a 4.1 percent rate, after a 7 percent pace of decline in the fourth quarter. The fall was universal -- at the federal, state and local levels. The U.S. government is in pullback mode, and whatever one thinks about reducing the size [of] government in the long run, for now it is unequivocally the villain in slowing growth. If there'd been no change in government spending over the last six months, GDP growth would have averaged a respectable 2.55 percent, not the current soft 1.45 percent.

But Irwin's last sentence begs the question. It amounts to saying that the Keynesian model is right about fiscal policy's potence. Certainly Irwin believes that and has a right to believe and write it. But Konzcal can't rely on that if he wants to claim that fiscal policy is more potent than monetary policy. Konzcal is using what I call "proof by assumption."

I titled this "Budget Cuts Seem to Work" because it's important not to make too much of one quarter of data. But to the extent this is a test of the potence of fiscal vs. monetary policy, monetary policy proved more potent. So why, in the title, is my emphasis on budget cuts, rather than monetary policy? Because my reason for advocating budget cuts is to reduce the size of government so that people can choose what to do with their own income. A cut in government spending, by definition, will do that. But the fear of Krugman and many others is that budget cuts will throw the economy into a recession. These budget cuts have not. 2.5 percent growth is not great, but it's not a recession and it's not even stagnation.

Also, we can be sure that when someone spends his own money, he will get, by his standards, at least a dollar's worth of goods and services for a dollar of spending. We can have no assurance that government will get a dollar's worth of value for a dollar of spending. The reason: government is spending other people's money. I wrote about this at some length in my article, "GDP Fetishism." So when government spending on goods and services falls by a dollar and private consumption spending rises by a dollar, even if the effects of that on GDP are neutral, the effects on well-being are highly likely to be positive.

I notice, by the way, that Tyler Cowen has started using my term, "GDP Fetishism." Thanks, Tyler.

HT to Scott Sumner and Bob Murphy.


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COMMENTS (18 to date)
Ken P writes:

The shallow perspective of those who point to lowered government contribution to GDP as "proof" that reduced government spending hurts the economy, really annoys me.

Here's my analogy: Suppose someone claimed that it's impossible to lose weight while wearing a coat. They could point to evidence that when you put on a coat, you weigh more on the scales. Coats prevent weight loss. This is backed up by rock solid evidence!

Thanks for the link to GDP fetishism.

MingoV writes:

There wasn't a 4% cut in federal spending. There was a 4% reduction of the desired budget. The actual reduction in federal spending over the past few months was not 4% despite the nonsense promulgated by the TSA, FAA, and White House.

I also don't believe the claimed GDP growth rate of 2.5% last quarter. That doesn't fit the employment data or the decline in durable goods orders. I suspect this is another economic figure that will be revised quietly and released to the media at 5 pm on the Friday before the Memorial Day holiday.

Hazel Meade writes:

Er, something else, besides budget cuts happened in the first quarter. Payroll taxes went up.
Every working adult saw a significant cut in their take-home pay.

John S writes:

David,

If Keynesians want more stimulus, then why not offer it to them in the form of a permanent payroll tax cut?

1. It would provide up to $100-200 billion per year in stimulus (depending on how it was structured).

2. It would reduce the tax burden of the poor and middle classes relative to the top 20% (since the bottom 3 quintiles pay around 7-9% of their income in FICA while the top quintile pays on 5.8%).

3. If we also reduce employer contributions, it would lower the costs of hiring new workers and spur employment.

The GOP should like it b/c, as you mention, it allows people to spend their income on themselves rather than have govt do it for them. The Democrats should like it b/c it raises the income of the poor and middle classes. In theory, there should be potential bipartisan support for this (although in practice there wasn't, since the cuts were allowed to expire).

Incidentally, Europe also seems to have even more room to cut payroll taxes, esp. of the employer contribution side: http://johnhcochrane.blogspot.kr/2012/09/europes-payroll-taxes.html

mark m writes:

Should economists let Keynesian economists call reductions in growth "austerity?" The CBO's budget analysis shows outlays for 2013 increasing over 2012 by $15B and 2014 increasing over 2013 by $55B. (Actual Dollars). Seems that austerity has been defined down to fit the packaging of a narrative that is favorable to those opposing reducing the growth of government.

CBO budget analysis

Daniel Kuehn writes:

John S -
The trouble with payroll cuts is that it causes problems with the trust funds. But some of us were saying something similar about the Bush tax cuts - that now is not the time to raise them. That message seems to have gotten through at least on the middle income cuts.

I suppose if you want to take a starve the beast approach to entitlement reform that's an option, but we're starting to get a little far afield from Keynesian macro at that point.

John S writes:

Daniel,

Right. And I realize anything related to SS is untouchable politically.

But in theory, we could cut payroll taxes now and plan for future implementation of something like Australia's privatized Superannuation Plan, which reportedly has been successful. http://marginalrevolution.com/marginalrevolution/2013/03/australia-notes.html

A payroll tax cut helps the working poor, gets them spending now, reduces hiring costs, and doesn't immediately jeopardize entitlement problems. On paper, what are the problems?

Daublin writes:

What mark m said. It's not austere when we are spending more than we did in the height of the Cold War.

Daniel Kuehn writes:

John S -
I think I went over the problems - it necessitates a fundamental change in entitlements which is a different discussion.

Which is why people talk about other taxes besides payroll. Why the insistence on payroll? Why not do the same thing through income taxes?

re: "I titled this "Budget Cuts Seem to Work" because it's important not to make too much of one quarter of data"

Actually there is far more data than that available. If you look at it, most of the time the faster government spending rises, the slower the private economy grows, and vice versa. The pattern is easy to see both in the US and around the world, as this page points out:

http://www.politicsdebunked.com/article-list/spendingpattern

It is easy to see, and trivial to replicate with public data, no involved statistics required. It doesn't address the issue of cause and effect, which is another story. It seems though that without sold evidence to the contrary (which doesn't seem to exist at the moment despite the likely protests Keynesians will make) that it is safest to assume increased government spending isn't good for the economy

One problem with GDP is of course that it only includes less than *half* of government spending (since it doesn't count e.g. transfer payments) so government's share of GDP doesn't give a good indication of its impact on the economy. In fact if you look closely, even most total expenditure figures for government don't give a complete picture (as the GAO and others have complained about for years).

There is 1 place in the yearly federal budget where you will see a reference to the true federal total spending, almost every other government figure ignores it, as this page points out,for instance:


http://www.politicsdebunked.com/article-list/goverment-hides-spending

The FY (Fiscal Year) 2013 proposed federal budget at the White House site has a Chapter 16 on "Offsetting Collections and Offsetting Receipts" where it explains: "For 2011 gross outlays to the pubic were $4152 billion [...] net outlays were $3,603 [...] Offsetting collections and offsetting receipts from the public are subtracted from gross outlays to the public to yield “net outlays,” which is the most common measure of outlays cited and generally referred to as simply 'outlays' ". The proposed budget figures are only "net outlays". Although the budget's "Historical tables" page has categories it claims are "Total outlays" or "Total Government Expenditures" they are only "net outlays". There doesn't appear to be a table of historical "gross outlay" data online. Almost every figure reported in any media is referring to "net outlays".


John S writes:

"Why the insistence on payroll? Why not do the same thing through income taxes?"

1. Payroll taxes hit the poorest quintile of workers much, much harder than income taxes. The bottom two quintiles pay 8.3% and 7.9% of their income in FICA, while receiving -9.3% and -2.6% in income tax benefits (2009 figures: http://www.cbo.gov/publication/43373).

So cutting income taxes won't really do much to help the low and middle-lower class. I'm no OWS-guy, but until we get a negative income tax, I favor tax relief targeted at the bottom first.

2. Reducing employer matching contributions would cut their hiring costs. This may induce them to hire more workers (esp. in Europe, where employer contributions are really, really high).

3. That said, I agree that cutting income taxes would be easier. But to really make a difference stimulus wise, you'd have to cut income taxes at the 4th quintile, households that are already quite well-off.

John S writes:

(cont)

Here are the income tax contributions by household income quintile as percentage shares of total federal income taxes:

Lowest: -6.6%
2nd: -3.5%
3rd: 2.7%
4th: 13.4%
Top: 94.1%

As you can see, bottom two quintiles don't pay anything, and 3rd pays very little. So you'd have to cut income taxes for the 4th and top bracket to really make a difference. Which is what several GOP pres. candidates proposed, but that came off as "tax cutting for the rich."

So, my suggestion is: aim tax cuts at the lowest classes first. Income tax doesn't hit them at all; payroll does. Incidentally, I'm not the only one talking about payroll tax cuts; just look at Google news.

(Btw, if I've read these excel files wrong, someone pls let me know. I wouldn't want to pull an R&R!)

John S writes:

Here's one more good chart:

Table 8. Percentage of Households Paying More in Payroll Taxes Than in Income Taxes, 2009

Lowest Quintile 99.4
Second Quintile 96.5
Middle Quintile 81.8
Fourth Quintile 54.4
Highest Quintile 14.2

So this shows again how much more of an beneficial impact payroll tax cuts would have than income tax cuts on the families that need extra money the most.

Charley Hooper writes:

Mike Konzcal is assuming that the government can and should drive economic growth and, because it can do it two different ways, we should ask which of the two is best.

This is government-centric. Perhaps the government isn't that important to the economy. Perhaps neither method of control is that powerful. And if they are potent, it may be that the government's current monetary and fiscal policies are hurting the economy.

We've had activist monetary and fiscal policy for years now and little to show for it.

Daniel Kuehn writes:

John S - I'm really not understanding your point. Why do you have to cut the fourth quintile? Strengthen the EITC. There are very obvious ways to help the lowest income brackets without wrecking the trust funds.

If the payroll tax got lowered as a part of a broader solution that included something like raising the FICA cap that would be fine. I've got nothing against a lower payroll tax. It just seems like there are lots of ways to address this population you're interested in without disturbing a whole lot of other policy questions.

...unless that's what your interest is, of course.

Michael writes:

Budget cuts work? There is little question that austerity will increase the output gap when the economy is below potential - like now.

John S writes:

Daniel,

Yes, that is something I didn't think of. I do need to learn the particulars of the EITC, I never understood how it works.

"...unless that's what your interest is, of course."

While I would like to see reform of entitlement spending, that's not my objective here. Just some random science fiction musings on how the D's and R's could get what they both want (D: fiscal stimulus, less inequality; R: tax cuts, smaller govt) in a parallel universe.

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