Intro: Fiscal stimulus measures often appear to work because the benefits that result are highly concentrated and visible while the costs are disbursed and invisible. When fiscal stimulus does ‘work’ it does so by preventing the emergence of idle resources resulting from the unwinding of economic imbalances, but in doing so it creates additional distortions.
Similar to activist monetary policy, fiscal stimulus tends to do more harm than good to economic growth, often even in the short term. There are various types of fiscal stimulus measures and their economic impact can differ markedly depending on whether the stimulus takes the form of tax cuts or spending increases. For our purposes we will focus on a general increase in spending or reduction in taxes across the board.
Not Necessarily Growth Positive, Even in the Short Term
While a rise in government infrastructure spending, for example, will tend to increase profit opportunities for certain sectors of the economy (mainly construction companies), the land, labour and capital required to build new infrastructure will tend to come at the expense of profit opportunities in other sectors. A government funded infrastructure project, for instance, may be detrimental for the residential real estate sector as real estate businesses find that profitability is lower as labour, land, bricks, and mortar now become costlier. Similar to monetary stimulus, fiscal stimulus merely puts more money into the economy without creating additional resources, putting upside pressure on inflation.
Similarly, tax cuts, even if they boost spending, will not necessarily boost economic growth. They may improve the perceived profitability of investment, but in the absence of spending cuts the net impact tends to be an increase in inflation. The reason is that tax cuts put more money in people’s pockets but they don’t increase the ability of businesses to create wealth. If one industry receives a tax cut, this will mean businesses in that industry will have greater ability to acquire inputs at the expense of businesses in other industries. If everyone receives a tax cut on the other hand, while it may seem as though investment is more profitable, when businesses go out and try to acquire inputs, they will find that the additional spending power just causes prices to increase, with no net impact on output.
We can look at this in terms of classic Keynesian framework of GDP = PC + GC + PI + GI + NX (where PC is private consumer spending, GC is government consumption, PI is private investment, GI is government investment, and NX is net exports). An increase in government investment resulting from a fiscal stimulus package or a rise in private spending resulting from a tax cut will just be offset by a reduction in next exports. This is why countries with large fiscal deficits tend to also have large external deficits.
When Fiscal Policy ‘Works’
There are times when fiscal spending or tax cuts can support economic growth in the short term, typically when they reverse or prevent the emergence of idle resources resulting from the unwinding of economic imbalances.
For example, if the economy is suffering the effects of an economic bust and unemployment is high, an infrastructure stimulus or tax cut can be a quick way of putting these idle resources back to work. After the Global Financial Crisis, US growth would have been supported by a stimulus programme or tax cuts that benefitted real estate construction. Those people left unemployed by the housing bust would have been re-employed and this would have lead to an increase in growth. That said, this increase in growth would have come at the expense of weaker growth in the future as economic distortions build creating a greater correction down the road.
Risks Posed by High Fiscal Spending
Similar to monetary stimulus, fiscal stimulus measures can create other distortions which outweigh the benefits of the stimulus in the first place. Increased fiscal spending would likely put downward pressure on the currency causing additional painful economic adjustments.
Over the longer term, high government spending tends to undermine long-term growth unless the spending is productive and thus improves the productivity of the private sector. High levels of spending on wasteful projects or subsidies or handouts will tend to reduce the amount of savings available for the private sector to invest. Even if taxes do not rise, the burden of the government on the private sector mainly reflects how much the government spends rather than how much it taxes.
Risks Posed by Low Taxes
While low taxes seem unequivocally positive for economic growth, there is more to it than meets the eye. Low taxes are positive for growth if they reflect a low level of government spending thus allowing the private sector to invest and grow. If spending is high and taxes are low, this will tend to undermine growth over the long term by resulting in high levels of government debt, which must be paid for by inflation or fiscal austerity. In the case of the former, high debt will limit the ability of central banks to increase interest rates due to the threat posed by higher debt servicing costs, creating further economic distortions. In the case of the latter, high debt loads mean that tax hikes or spending cuts will have to come, creating potential economic shocks.
It is also worth adding that if a government runs a persistent fiscal surplus, this is not some kind of drag on economic growth. If taxes are higher than spending, one of two things will happen: A) the government will use these savings to invest in overseas assets, so external savings will rise. B) the money will remain in the treasury’s coffers and effectively out of the money supply, so the after-tax earnings that citizens receive become worth more in real terms.
A quote from Milton Friedman may provide more clarity on this:
“Keep your eye on one thing and one thing only: how much government is spending, because that’s the true tax. If you’re not paying for it in the form of explicit taxes, you’re paying for it indirectly in the form of inflation or in the form of borrowing. The thing you should keep your eye on is what government spends, and the real problem is to hold down government spending as a fraction of our income, and if you do that, you can stop worrying about the debt.”