Fiscal Policy: The Unused Tool

You see it’s all about spending, hear the register cha-ching
Circular flow, the dough is everything
So if that flow is getting low, doesn’t matter the reason
We need more government spending, now its stimulus season
- Fear the Boom and Bust

"Stimulus season" began with the passage of the Economic Stimulus Act of 2008, continued with the Housing and Economic Recovery Act of 2008, and proceeds with the American Recovery and Reinvestment Act of 2009. In order to eliminate the recessionary gap, the federal government, and the state and local governments to a lesser degree, have allowed their collective budget deficit to increase (see Figure 1). However, it is misleading to use the government borrowing-to-GDP ratio to gauge the expansiveness of fiscal policy. A closer examination reveals that the fiscal stimulus has been puny at best.

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What Is Expansive Fiscal Policy?

The expansiveness of fiscal policy should not be estimated using the government borrowing-to-GDP ratio because it assumes that government expenditures are homogeneous. Government purchases of produced goods and services, classified as either consumption expenditure or (gross) investment expenditure, are included in the calculation of GDP. Transfer payments (e.g., employment insurance and welfare payments, as well as interest payments) are omitted from GDP as the payment is not made in exchange for a good or service. Likewise, forms of financial saving, such as the purchase of financial securities, are excluded in the calculation of GDP. Thus, only an increase in government consumption and investment expenditures is considered expansionary. The government borrowing-to-GDP ratio also does not consider the cause of a decrease in tax revenue.

The government borrowing-to-GDP ratio is misleading because it does not take into account that tax receipts may fall due to a decline in GDP. Taxes not collected as a result of a fall in GDP do not amount to tax relief, and is not an expansive fiscal policy. Conversely, a tax credit policy, such as the first-time homebuyer tax credit, is expansionary. All in all, a fiscal policy is said to be expansive if the sum of tax relief, government consumption expenditure, and government investment expenditure has increased relative to the previous fiscal period.

The Expansiveness of Fiscal Policy since the Beginning of the Recession
The Economic Stimulus Act of 2008, enacted in the first quarter of 2008, marks the beginning of the active use of fiscal policy to eliminate the recessionary gap. Accordingly, the fourth quarter of 2007, a period absent of recession-combating fiscal stimuli, may serve as a basis against which the expansiveness of future fiscal policies may be gauged.

While the collective government budget deficit has risen, the greater deficit is not principally due to an increase in government purchases (see Figure 2). Since the beginning of the recession, the decrease in tax revenue (due to the recession) has been greater than the rise in government purchases. From 2007:Q4 to 2010:Q1, the fall in taxes collected amounted to approximately 15%, whereas government purchases rose by around 8%. As opposed to a considerable increase in government consumption and investment expenditures, it is actually a significant rise in transfer payments which has occurred as they increased by approximately 26% from 2007:Q4 to 2010:Q1. Contrary to popular belief, a sizeable increase in government purchases has not occurred.

Overall, fiscal policy has been wishful and naïve. Unless the multiplier is unusually high, an output gap which varies from 0.9% to 7.0% of real potential GDP will probably not be eliminated by fiscal stimuli which range from 0.4% to 2.0% of GDP (see Figure 3). Policymakers have hoped that a combination of relatively small amounts of tax relief and increases in government purchases, as well as policies which aim to stabilize prices and confidence (e.g., FHA Modernization Act of 2008, HOPE for Homeowners Act of 2008, Cash for Clunkers) would initiate a significant revival of private consumption and investment expenditure. Policymakers have failed miserably, and the double-dip whispers should be taken more seriously.

Conclusion

A fiscal policy is described as expansive if the sum of tax relief and government purchases has risen relative to the previous fiscal period. Since the beginning of the recession, fiscal stimuli have ranged from laughable to puny. With regards to the use of fiscal policy during the 1930s, Professor E. Carey Brown of MIT, has noted in a study that, “[f]iscal policy seems to have been an unsuccessful recovery device in the thirties – not because it did not work, but because it was not tried.” It appears that the mistakes of the thirties are currently being repeated.

Disclosure: No positions