Effectiveness of Fiscal Policy as a Stabilization Tool

Topics: Taxation, Public finance, Taxation in the United States Pages: 29 (9755 words) Published: November 11, 2011
The Effectiveness of Fiscal Policy as Stabilization Policy
Alan J. Auerbach University of California, Berkeley July 2005

This paper was presented at the Bank of Korea International Conference, The Effectiveness of Stabilization Policies, Seoul, May 2005. I am grateful to my discussants, Takatoshi Ito and Chung Mo Koo, and other conference participants for comments on an earlier draft.

I. Introduction
Perspectives among economists on the usefulness of fiscal policy as a device for macroeconomic management have moved back and forth over the years. Belief in the active use of the tools of fiscal policy may have reached a relative peak sometime during the 1960s or early 1970s, and practice followed theory. In the United States, perhaps the best illustration of the evolution of theory and practice comes from the investment tax credit (ITC), which, when it was in effect, provided businesses with a strong incentive for equipment investment. The ITC, first introduced during the Kennedy administration in 1962, at a rate of 7 percent, was adjusted frequently in response to changes in economic conditions. It was strengthened in 1964, the same year in which major income tax reductions were introduced, suspended in 1966 during a boom associated with the Vietnam War, reinstated in 1967, “permanently” repealed in 1969 during a period of inflationary pressure, reinstated again in 1971, just after the trough of the first recession since early 1961, and increased to a rate of 10 percent in 1974, toward the end of the next recession. Although not necessarily conceived originally as a tool for stabilization policy, the ITC clearly became one during this period. Yet, skepticism about the usefulness of such activism soon appeared. In an early evaluation of the effectiveness of the credit, Gordon and Jorgenson (1976) concluded that the actual variations in the ITC just described had destabilized the economy. They argued that some of the policy changes were timed poorly, and that others were simply in the wrong direction. Using the large-scale Data Resources, Inc. (DRI) quarterly econometric model of the U.S. economy, a benchmark model at the time, they calculated an optimal historical path for the ITC, the path of switching the credit on and off that would have

minimized the fluctuations in the gap between actual and potential GDP. Under the unrealistic assumption of no policy lags, their optimal policy was superior not only to actual policy, but also to a constant-rate ITC policy. With policy lags, though, the performance of the optimal activist policy deteriorated, to the point that, with an assumed lag of 10 quarters, the optimal activist policy was no better, and under some assumptions worse, than a constantrate policy. Thus, Gordon and Jorgenson concluded, a realistic policy environment made activist use of the ITC much less attractive. Although policy lags were not a newly-identified problem in the 1970s, it was not until then that researchers had a period of activist fiscal policy practice sufficient to study. One might have come away from the analysis of Gordon and Jorgenson and others with the view that activist policy was more difficult that its designers had realized but not necessarily bad. But the intellectual assault on activist fiscal policy – indeed, in the specific form of the investment tax credit – soon took a much stronger turn, in celebrated papers by Lucas (1976) and Kydland and Prescott (1977). Lucas argued that one couldn’t use models like the DRI model to determine the optimal path of the ITC, because the model’s parameters were not exogenous parameters of preferences and technology, and hence were dependent on the actual policy environment; a change in policy would induce a change in the model’s parameters, and so one could not evaluate the performance of counterfactual policies. Kydland and Prescott emphasized the dynamic inconsistency of optimal government plans. The path for the ITC that would be optimal...

References: Source: Fátas and Mihov (2003), Figure I
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