Who would have thought it? After two decades during which government economic activity has been under attack, even on the retreat, there is a renewed and vigorous interest in fiscal policy in the United States. This is partly because of the serious events of 2001 that reminded us of the value of government, but it is also due to the recession, which has highlighted government’s role in stabilising market economies.
Aided by the smooth workings of automatic stabiliser mechanisms such as the progressive income tax, the huge on-budget surplus disappeared. This has helped dampen the recession’s impact and highlighted the virtues of tried and trusted Keynesian principles of mobilising government money to steady the economy. When interest rates were higher, recessions could be fought by lowering them, which immediately reduced debt service burdens. In particular, families could refinance their mortgages with lower, more affordable rates, thereby freeing up disposable income. Now that inflation and interest rates are both down, monetary policy has less room for manoeuvre, increasing the need for alternative mechanisms to combat demand slumps.
Automatic stabilisers are one channel through which fiscal policy can help combat recessions; discretionary fiscal policy is another. Here, the record of 2001 is less sanguine. Though presented as immediate fiscal stimulus, the individual tax cut of spring 2001 was in fact little more than a back-loaded tax redistribution to the wealthy. Thus, 47.1% of the benefits go to the top 5% of income earners, and because many of the provisions are phased in over the next 10 years, it significantly worsens the long-term fiscal outlook. Good discretionary fiscal policy should provide immediate stimulus by getting money to those who will spend it, and it should “sunset” when recovery begins.
The spring 2001 tax cut largely failed both of these tests. Another area where policy failed was unemployment insurance (UI), which was held hostage to demands for corporate tax relief. UI is perhaps the single most effective instrument of fiscal stimulus, in that it reaches those who need income most and who will spend it all. Moreover, as the unemployed are often geographically concentrated, unemployment insurance helps whole communities. Finally, the importance of UI diminishes – as counter-cyclical policy should – when the unemployed find new jobs.
Yet, despite these clear benefits, action on UI was blocked by political demands for corporate tax relief. In some instances, this relief contained little stimulus value, either because it rewarded old investments already in place or because it cost a lot. For instance, the proposed investment tax credit made no attempt to target marginal investment spending and instead rewarded all investment spending, including that which would have taken place with or without the tax credit.
Public infrastructure investment is another area where policy can be strengthened. The 28 September terrorist attacks prompted some increased spending in the form of re-building assistance, and defence and security expenditures. But more is needed. Infrastructure spending can be effective as a generator of jobs, and it can also help address long-unfilled needs and enhance future productivity. Another useful fiscal policy for speeding recovery is federal aid for states. Since many states are subject to balanced budget rules, downturns lead to pro-cyclical cutbacks in state spending, making matters worse. Federal aid for states can mitigate this consequence of state budget rules. If the recession continues in 2002, such aid should be a focal point of federal fiscal policy action.
Thankfully, the era of fiscal repair to resolve unsustainable deficits is over. Looking ahead, government should renew its commitment to the principles of a good tax system –sufficiency, fairness, efficiency and economic stability. Unfortunately, many of the discretionary changes in US tax policy in 2001 betray these principles. The tax cut was unfair because it was skewed towards the richest segments of the population, and its phased-in design promises to reduce future revenue streams in such a way that there will be insufficient resources to meet America’s public service and infrastructure needs. This suggests that policymakers should repeal the 2001 tax cut. However, this will be a difficult message to craft. On the one hand, fiscal stimulus may still be needed if the recession continues. Yet on the other hand – and superficially in contradiction – the 2001 tax cut should be repealed because it undermines the long-run fiscal outlook and provides minimal fiscal stimulus.
• Godley, W., “Kick-start strategy fails to fire spluttering US economic motor”, in The Guardian, United Kingdom, 21 January, 2001; see http://www.guardian.co.uk/Archive/
©OECD Observer No 230, January 2001