Stimulus and Tax Cuts: Who are we Kidding?

Originally published in the NV and CA Examiner 10/08/2010 issue

     The common politician always argues that "we need to increase spending in the economy," as opposed to spending cuts, since "this is what is needed to speed up economic recovery."  From all angles, the current Administration's policies are built along this framework. On the contrary, history reveals that in fact it is the "cuts in spending to reduce deficits" which became the key to promote economic recovery. Where does the myth end and the reality begin?

     Today, we bear witness to the U.S. economy being bombarded with government spending through various stimulus packages with the expectation that the multiplier effect the Administration's economists are anticipating for will trickle down to increase in gross domestic product (GDP).  Sorry, Senor y Senoritas, the answer we have for now is "Nada." The effect on GDP is just too small we call them "de minimis" in the tax world.

     The flip side of this story is that stimulus spending is actually scary. It means that tax increases are coming! And more often than not, tax increases is a threat to economic growth! …..." Oh yeah! Where’s your evidence?” you may ask…..

     Well here’s the evidence….

     In a recent study conducted by Alberto Alesina and Sylvia Ardagna, Professors of Political Economy at the Harvard, they concluded that:

            (1) Large adjustments in fiscal policy if based on well-targeted spending cuts have often led to expansions, not recessions.

            (2) Fiscal adjustments based on higher taxes, on the other hand, have generally been recessionary.

     The study covered 107 large fiscal adjustments that took place in 21 countries between 1970 to 2007. According to their economic model, the results were striking. Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases.

     Let’s look at the scenario why spending cuts can be expansionary:

First and foremost, such a policy will signal that no tax increases will occur in the near future, or even if did, it will be relatively smaller. Government should present a transparent and credible plan that will surely cut outlays. This will therefore create an impression in the minds of the people that no changes on future tax liabilities are coming. Subsequently, this will be transferred and manifested in the behavior of consumers and more importantly investors who will be willing to spend and invest, since both camps foresee no tax increases, at least over a sustainable period.

      On the contrary, fiscal adjustments based on tax increases will reduce the disposable income of consumers and subsequently reduce incentives for productivity.

     In today’s U.S. economy, there are still a lot of firms that are profitable. The problem is, they do have large unspent idle resources due mainly to uncertainty over the regulations on taxes, which directly discourage them from taking risks in investments as well as consumption.

     In conclusion, we are able to discern that the United States is at a greater risk from the increased Obama’s stimulus spending rather than undertaking gradual and credible spending cuts. The evidence from the last 40 years does not lie. Spending increases that is meant to stimulate the economy and tax increases to reduce deficits just don’t work.  The writing is on the wall! Who are we kidding?