Validity of the Tax Multiplier Argument Against Above Average NAIRU

Over the course of the past few days the debate over what strategies need be employed in an effort to close a reasonable fraction of the GDP gap that is predicted to occur in 2009(about $900 billion below normal growth path) has intensified. Perhaps as a result of the recent unemployment report (including U-6 at 12%), or perhaps as more is revealed about the Obama Administration's planned infrastructure spending, and more likely a combination of the two. As always, much of the clash surrounds selecting the appropriate model(s) as a backdrop for strategic decision-making, with focus on the tax and spending multipliers.

As noted previously, economists Susan Woodward and Robert Hall have identified five general stimulus-inducing strategies including further expansion by the Fed, income tax cuts with rebates, tax cuts that reduce the prices of consumer goods temporarily, tax cuts that reduce the cost of labor to businesses, and an increase in purchases of goods and services by state and local governments. While I've been consistently in support of continued and expanded government spending, and not quite convinced tax cuts will prove as successful in this environment, Woodward and Hall have expanded their argument to suggest that the spending multiplier is merely 1 for 1, perhaps a fraction of the tax multiplier, leading to the notion by some that the focus should be on tax cuts (most likely in the form of cuts in payroll taxes). This view is counter to the traditional Kenseyian model.

The two suggest, after viewing spending increases from World War II and the Korean War, that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. As noted economist Greg Mankiw points out:

"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. 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. Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes. 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."

I take issue with the notion that the tax multiplier is greater than the spending multiplier, or that tax cuts will be more effective than government spending in stimulating GDP, in the current economic environment. First, as Nobel Memorial Prize in Economic Sciences recipient Paul Krugman points out, significant flaws exist within Hall's and Woodward's argument: specifically avoidance/denail of certain historical realities which understate the findings. Secondly, in this recessionary environment of steep unemployment, significant downward pressure on labor costs already exists. Would further downward forces on the cost of labor truly encourage increased hours, re-hiring, or less firing? Doesn't the spate of downsizing reflect the businesses need to align current revenues with current costs? I'd happily concede that such a tax cut would decrease the cost of labor further, but I'm not convinced the newly employed or re-employed would immediately begin consuming, as opposed to saving and paying down debt. As for the spur in capital investment by businesses that is suggested, one need look no further than where a majority of the TARP money has been positioned: short-term treasuries now yielding .005%.