Smith Faculty Opinion Article

By Dr. John A. Haslem, Professor Emeritus of Finance E-MAIL WEB SITE

The 30 Seconds Outlook
March 1, 2010

The Obama Administration continues to assert the now $862 billion stimulus package saved jobs and moderated the recession. There is also talk of a second stimulus of smaller size. The basic question in all of this discussion is how well did the first stimulus work?

There are many voices on this issue, but no one has done a better empirical analysis of past fiscal actions than macroeconomist Robert Barro. He asks whether additional government deficit spending and taxes increase or decrease personal consumption, private domestic investment, and net exports.

Long-term macroeconomic data are used to estimate the effects on GDP from increased public spending (“spending multiplier”) and from increased taxes (“tax multiplier”).

The spending multiplier is estimated at 0.40 in year one and 0.60 in years one and two. The multiplier is less than one, which provides less in additional GDP than the amount of additional government deficit spending. Government deficit spending of $300 billion in each of the years 2009 and 2010 replaces private economy increases in GDP with government security holdings. The $600 billion in additional government deficit spending increases GDP by only $120 billion in 2009, $180 billion in 2010, and $60 billion in 2011, a total of only $360 billion and a loss of $240 billion in personal consumption, private domestic investment, and net exports.

The tax multiplier is estimated using average marginal income tax rates, which are applied to federal and state income taxes and Social Security payroll taxes. The relationship between tax rates and tax revenues estimates a tax multiplier of minus 1.10 in year one. A tax increase of $300 billion in 2010 and in 2011 removes $600 billion from generation of GDP in the private economy and further reduces GDP by $30 billion in 2011 and in 2012, a $660 billion reduction in GDP.

The $600 billion total increase in total government spending generates a correspondently larger federal debt, which requires additional future taxes unless spending declines below its 2008 level. There is no “free lunch” for government spending.

In sum, the so-called “fiscal stimulus” of $600 billion in additional government deficit spending generates a $240 billion loss in GDP due to the spending multiplier and a loss of $660 billion in GDP due to the tax multiplier. This is consistent with the “balanced-budget multiplier” that finds government deficit spending and higher taxes have a negative effect on GDP.

What do these reductions in GDP say about government tax and spend policies? Would you hire the government to manage your portfolio?

John A. Haslem