Monday, December 6, 2010

Fed President Suggests Using Tax Incentives As Fiscal Stimulus

Mark Thoma, Professor of Economics at the University of Oregon, agrees with Narayana Kocherlakota, the President of the Federal Reserve Bank of Minneapolis that the government should do more in terms of fiscal policy to stimulate the economy. Kocherlakota suggests using tax incentives to stimulate the economy in 2011 but Thoma doubts there is enough political will for this policy to be implemented. See the following post from Economist's View.

On many occasions when the Fed was dragging its feet in terms of implementing a second round of quantitative easing, I made the claim that fiscal policy authorities don't have to wait for the Fed to take action, they can use tax changes to duplicate the incentives that are created when the Fed lowers the interest rate. Furthermore, while the Fed may have difficulty cutting interest rates as much as needed when the interest rate is near the zero bound, fiscal policy authorities have much more room to maneuver.

I missed this speech by Narayana Kocherlakota when it was given a couple of weeks ago, but it makes this point explicitly:
Monetary Policy Actions and Fiscal Policy Substitutes, by Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis: ...I’ll begin by discussing current macroeconomic conditions and the Federal Open Market Committee’s recent actions...

This is the economic situation that confronted the FOMC in its November meeting. Inflation and employment are both too low, and the pace of recovery is too slow. Economic growth is low and softening further. I think it is safe to say that, given this situation, the FOMC would have liked to have been able to cut its target interest rate. But this option is not available. ...

But the FOMC does have another policy instrument available: its balance sheet. ... At its November 3 meeting, the FOMC announced that it plans to buy $600 billion of long-term Treasuries in the open market by mid-2011. ... This kind of action is known as quantitative easing, or QE. ...

I believe that QE is a move in the right direction. However,... I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible...

Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative.2 Their key insight is that there is a broad equivalence between monetary and fiscal policy. ...

In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay.3 The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut. ...

The 1 percent permanent consumption tax that begins in 2012 stimulates consumption demand in 2011. The permanent reduction in labor income taxes ensures that this new consumption tax does not deter labor supply. Finally, the investment tax credit makes sure that the new consumption tax does not deter investment in 2011.

I’ll make two additional comments about this plan. First, how much would this three-pronged change in taxes cost the American taxpayer? The exact answer to this question would depend on a host of details... But let me offer a very rough calculation..., the first two parts of the plan would add about $20 billion per year to government revenue beginning in 2012. The plan also involves an appropriately sized investment tax credit..., a one-time cost in 2012 of $20 billion. These calculations, while obviously very rough, do indicate that the plan has the potential to be fiscally responsible.4

Second, I’ve not discussed distributional considerations. Raising consumption taxes by 1 percentage point and lowering labor income taxes by 1 percentage point for all Americans would tend to redistribute the burden of taxes toward lower-income citizens. For this reason, I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.

Overall, I believe that this analysis has both policy and intellectual aspects. From a policy point of view,... I find the resultant policy to be attractive because may be able to generate macroeconomic stimulus without increasing the deficit. From an intellectual point of view, the analysis demonstrates the remarkable power of public finance in addressing important macroeconomic questions. ...
The point is that the effects of QE are likely to be modest, and with unemployment remaining persistently high, we need to do more than monetary policy has to offer. Thus, fiscal policy has a key role to play, either through direct spending on infrastructure and other projects -- my first choice -- or through tax schemes designed to create incentives for increased economic activity.

Monetary policy has done all it can do, pretty much. I would like to see the Fed be even more aggressive, but even if it did implement a larger QE program, it can't do enough to solve the economic growth and unemployment problems by itself. Fiscal policy authorities need to step up and do more -- statements like the one above and those made recently by Ben Bernanke are pleas for help from fiscal authorities. But, unfortunately, Congress has fallen down on the job, there is no leadership from the White House promoting such action, and there is very little hope, none really, that more help will be forthcoming.

This post has been republished from Mark Thoma's blog, Economist's View.
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