Fiscal Policy after the Great Recession
Alesina, Alberto, Atlantic Economic Journal
There are many things that we as economists know and many things we do not know about fiscal policy. There are many things that we agree upon, but even more things we do not agree upon. I am going to begin by discussing what we agree upon with fiscal policy. For a much more extensive discussion of these issues, see Alesina and Giavazzi (2013).
The tax smoothing principle is one example of what we agree upon. It is the idea that it is good to allow deficit to increase during recessions as long as they are compensated by a surplus during booms. The goal is to keep tax rates stable and allow the deficit to fluctuate over the cycle. It would be a bad idea to raise taxes during a recession and to cut taxes during a boom. On the spending side, automatic stabilizers have to do their work. It is perfectly fine to allow, for example, unemployment compensations to go up during a recession. If this causes a deficit, so be it, as long as they are compensated for by surpluses when the recession ends. This implies that balanced budget rules are a bad idea. That is, it is a bad idea to balance the budget every period, because it goes against the basic economic principle of tax smoothing.
However, this basic principle of tax smoothing is unfortunately not often followed by policy makers. They are content to let deficits grow during recessions and are less comfortable to reduce them during surpluses. As a result, a balanced budget may be a second best against this political distortion.
There are also things that economists do not agree upon. There are two critical issues that are really at the forefront of the political debate. First, in addition to the automatic stabilizers, when should discretionary counter-cyclical policies be used? Namely, during a recession should we actively cut taxes or increase discretionary spending in a Keynesian fashion?
The second thing we do not agree upon is: what is the effect of a tax or spend policy? What is the size of a tax multiplier from government spending? That is, if a government increases spending by $1.00, what is the effect on the economy? Does increased government spending cause a decrease in private sector spending? The answer to the question about the size of the multiplier is crucial in deciding whether or not this discretionary policy is a good idea on the expansionary side and whether or not budget cuts are particularly costly.
There are two reasons why we disagree upon this issue. One reason is that these are very highly politically charged issues about the role of the state. Governments' involvement in private sector activities creates a very big ideological divide. Leaving that aside, there are a lot of economic reasons why the problem is difficult, which has to do with the fact that it is essentially very difficult to disentangle what the effects are of government spending (G) and taxes (Y) on Gross Domestic Product (GDP) because it is difficult to measure the co-movement of these three variables. For example, if G goes up during a recession and tax revenues go down, the ratio of the deficit over GDP goes up during a recession, but that does not mean deficits cause the recession. It simply means that the denominator goes up, and vice versa during a boom. More generally, spending, taxes, and GDP are highly inter-correlated and it is very difficult to isolate the exogenous effects and changes of government spending on GDP.
The second reason why we disagree is that when we examine the cost of fiscal adjustments, it is very difficult to figure out the exact cost of budget cuts because there are many things which occur at the same time. For instance, what is happening to monetary policy, what is happening with the exchange rate, what is happening to the price of oil or to wage setting agreements all matters. It is very difficult to isolate the effects of fiscal policy. Therefore, the problem is inherently difficult. As economists, we should be more ready than we actually are in admitting that there are a lot of things that we do not know and be careful not to claim more than we actually know. …