From Textbook Stimulus Fallacy to Dow 10,000

Missing Tax Cut Multipliers Make all the Difference

There is, it seems, a fallacy in textbook economic theory. Harvard economist and best selling textbook author Greg Mankiw points out in the New York Times that while textbook Keynesian economics suggests federal spending is more effective than tax cuts at stimulating the economy, empirical evidence suggests otherwise.

Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.

In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment. Most is for what the government has ordered, which raises the next question.

WILL THE EXTRA SPENDING BE ON THINGS WE NEED? If you hire your neighbor for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the G.D.P. rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off... If the stimulus package takes the form of bridges to nowhere, a result could be economic expansion as measured by standard statistics but little increase in economic well-being...

MIGHT TAX CUTS BE MORE POTENT? Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.†

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out.

One wishes Prof. Mankiw would do a bit more informed conjecturing in the Times, because the answer to the above puzzle could greatly inform the current stimulus debate. It is likely there is more than just one factor at play here. Prof. Mankiw at least offers one explanation here why the multiplier for spending stimulus may be so low: too many bridges to nowhere, too much useless digging-and-filling ditches drags down the spending multiplier. But hidden elsewhere in his blog, Mankiw more powerfully explains the higher multiplier for tax cuts:

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... 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.††

All the above clearly applies to the current debate over whether corporate tax cuts should be included in the stimulus package, with critics making the same textbook arguments that businesses might save rather than invest the tax cut, while federal spending is surely spent.

However, it seems to me that when the Mankiw hypothesis is applied to corporate tax cuts, (which is a cleaner thought experiment than a payroll tax in that we don't need to consider the employee tax cut) not only does it become crystal clear that Mankiw MUST be right about price changes boosting investment demand, but that there is an additional market mechanism in play here, boosting both aggregate demand and hence the tax multiplier.

Let's follow the chain of cause and effect: corporate tax cuts would mean higher after-tax earnings; since earnings determine stock prices through P/E ratios, higher earnings forecasts would signal a immediately higher market value for each corporation and the stock market as a whole. Rising values will pull investors back into the market. Further, a rising stock market generally means rising consumer spending and demand as individual see their net worth recover and deferred needs become pressing. Lastly, rising demand would further determine that corporate tax cuts would be invested, not saved, again, in direct contradiction of the above textbook expectations.

How does this work out in the current market? Doing the math, we see that cutting combined federal-state corporate rates 15 percentage points from the present 39% to say 24% (making US rates in line with average corporate rates in OECD countries) would raise corporate after-tax earnings by about 24.6%. If P/E ratios are stable, it is likely that both corporate valuations and stock markets would rise by roughly the same percentage, around 24.6%, in a fairly short period. If the current market floor is at about DOW 8000, that implies that a 15% corporate tax cut would raise the value of the DOW to just under 10,000. This number could be higher if P/E ratios rise (as is usually the case in rising markets) or if a significant portion of investors use leverage. Subsequent rising demand could further boost the Dow significantly above 10,000, driving a powerful positive feedback loop that boosts demand and GDP further.

While I leave it up to others to quantify tax cut multipliers, it is easy to see where additional equity and debt market multipliers kick in, and what has been left out of the textbook theory: some of the new investors will use debt for leverage (creating an additional credit market multiplier) or pull money out of savings (in contradiction to textbook models that result in low multipliers). Further, as with the new investment, the new consumption will also be partly financed from debt or savings, credit markets again boosting demand and the tax multiplier. Lastly, facing stronger demand, businesses would not only invest their tax cuts, but seek more equity and debt financing, creating an additional leverage multiplier. Higher stock valuations (the direct result of tax cuts) would further strengthen balance sheets and allow corporations to borrow more money more cheaply.

At nearly every step of this chain of causation, we further see that the textbook Keynesian assumption that the tax cut will be saved rather than invested is powerfully contradicted, that the tax cut would be not only fully invested but also attracts additional debt or equity financing at three different levels: that of the investor, consumer and corporation.

By contrast, no such equity+credit market multiplier effect could be plausibly attributed to federal spending, which seems instead to actually crowd out private investment.

Prof. Mankiw observes:

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.

He refers to his own hypothesis, of course, but it is equally true of my elaboration on equity and debt market multipliers, and probably applies to a broad variety of tax cuts (and regulatory relief) that effect the value of investments. This hypothesis could be further verified if research shows the following: (a) that corporate tax cuts lead to rising stock markets; and (b) that rising stock markets lead to rising consumer spending.

To correct the spending stimulus fallacy, future economics textbook should say that every dollar of federal spending is either spent or misspent, but every dollar of tax cut is not only invested, but attracts many more dollars of additional investment by raising underlying valuations.

Addendum: So why post this here on a blog about green energy tax cuts? Because not only is the proposed stimulus worth writing about, but all the above bolsters the case for supply-side green tax cuts, which should also boost GDP by $3 for every dollar of tax cut, according to the empirical research cited above. I can't help noticing that Mankiw is the founder of The Pigou Club, arguing for Pigouvian tax adjustments to take into account market externalities. Now this may come as a surprise, but I am applying for admission to the club on the grounds that green tax cuts are indeed a legitimate Pigouvian tax adjustment to account for positive and negative externalities of various energy technologies. That I oppose carbon or gas taxes on account of the $3 of GDP loss they create for every dollar of tax, or believe Pigouvian tax cuts are superior to Pigouvian tax hikes is merely a matter for thought-provoking internal debate among club members, and should not bar me from admission, or full enjoyment of club facilities...

†Prof. Mankiw points to other empirical evidence of low spending and high tax cut multipliers here, here and here. Christina Romer is President Obama's appointee as chairwoman of the Council of Economic Advisors.

††Mankiw's hypothesis is similar to the explanation offered by supply-side economics: tax cuts make it more rewarding to work and invest, and less rewarding to employ accountants and tax shelters: therefore a tax cut gets us more work and investment. But supply-siders go one step further by suggesting that the highest tax multipliers are associated with cuts at the highest marginal rates, that since the highest rates create the severest disincentives to work and invest, the magnitude of the economic benefit for a cut at these rates will be greatest, as will the likelihood that such cuts will be revenue positive or neutral.