Economic Stimulus: What characteristics make fiscal stimulus most effective?
Fiscal stimulus can raise output and incomes in the short run when the economy is operating below its potential. To have the greatest impact with the least long-run cost, the stimulus should be timely, temporary, and targeted. It should be timely so that its effects are felt while economic activity is still below potential; when the economy has recovered, stimulus becomes counterproductive. It should be temporary to avoid raising inflation and to minimize the adverse long-term effects of a larger budget deficit. And it should be well targeted to provide resources to people who most need them and will spend them: for fiscal stimulus to work, it is essential that the funds be spent, not saved.
- Making fiscal stimulus timely is especially challenging because it involves not just enacting tax cuts or spending increases but also implementing them. In the worst case, poorly timed fiscal policy adds instability to the economy, intensifying rather than damping the business cycle. If fiscal stimulus is enacted too slowly, not only might it fail to prevent a drop in output and incomes, but the stimulus might arrive after recovery has begun, leading to overexpansion and higher inflation.
- Fiscal stimulus should be temporary because, in the long run, the Federal Reserve generally keeps the economy operating close to full employment and full capacity. This means that, most of the time, fiscal stimulus would not increase output but instead simply raise inflation or induce the Federal Reserve to run tighter monetary policy in order to keep inflation down.
- Over the long run, permanent tax cuts or increases in government spending that are not matched by changes on the other side of the ledger reduce national saving, resulting in lower investment or more foreign borrowing. This, in turn, diminishes economic growth and future national income. Also, larger expected budget deficits tend to push up long-run interest rates, which restrain investment and weaken net exports by pushing up the value of the dollar-effects that will undo part or all of the direct stimulative effects of lower taxes or higher government spending. Therefore, a temporary stimulus is likely to be more effective than a permanent policy change at a much lower long-run cost. Temporary stimulus will be even more effective if it is actually paid for over five or ten years, to avoid raising the long-run path of federal debt.
- Fiscal stimulus should be well targeted in two ways. First, it should go to those households or businesses most likely to raise spending in response to the stimulus and thus increase GDP in the short run. Second, it should provide the greatest benefit to those people most adversely affected by the slowdown. These two aspects of targeting are complementary. Higher-income households can generally smooth their consumption over the business cycle by drawing down their savings or borrowing. Therefore directing resources to them will likely have little effect on consumer spending. In contrast, lower-income families are more likely to have to cut back their consumption in hard times. These families are likely to spend any additional money they receive from tax cuts or transfer payments, which thus help protect them from the downturn while also boosting the overall economy.
- Research has found that tax rebates to households rapidly increase consumer spending and hence short-run economic activity (see tables 1 and 2). An across-the-board rate reduction is much less effective than a flat tax cut per household, and capital-oriented tax cuts (such as reductions in the tax rate on dividends or capital gains) provide little short-run stimulus. Policies that target the people most affected by an economic slowdown, such as the long-term unemployed, have the biggest bang for the buck-the largest increase in GDP for a given cut in taxes or increase in outlays. In contrast, few firms appear to respond to bonus depreciation for business investment, and the maximum effect on investment occurs after three years, well after fiscal stimulus would be most helpful.