Spending and Tax Multipliers
So what are these multipliers? In their new blog, Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. Similarly, the results in Valerie Ramey's research suggest a government spending multiplier of about 1.4. (Valerie does not present her results in multiplier form, but she emails me this translation: "The right column of figure 5A of my paper shows that for a log change of government spending of 1, log GDP rises by 0.28, implying an elasticity of 0.28. To back out the implied multiplier, we can use the fact that government spending averages around 20% of GDP. This implies a multiplier of 1.4.")
By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.
How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favorable to capital investment--a mechanism absent in the textbook Keynesian model.
Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit.
This hypothesized channel seems broadly consistent with the empirical findings of Blanchard and Perotti, Mountford and Uhlig, Alesina and Ardagna, and Alesina, Ardagna, Perotti, and Schiantarelli. The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy.
My advice 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.