Activist Fiscal Policy to Stabilize Economic Activity

Alan J. Auerbach and
Alan Auerbach Headshot
Alan J. Auerbach Robert D. Burch Professor of Economics and Law - Economics Department, UC-Berkeley, Director - Robert D. Burch Center for Tax Policy and Public Finance
William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

August 24, 2009

Facing the most severe recession since the 1930s, and probably the longest as well, the U.S. government has adopted an aggressive countercyclical fiscal policy stance, beginning with the “Economic Stimulus Act of 2008” in February of that year, shortly after the recession’s designated starting date, and followed one year later by the much larger “American Recovery and Reinvestment Tax Act of 2009.” These two bills, adopted under different presidents, both contained temporary tax rebates for households and temporary investment incentives for firms, indicating at least limited bipartisan acceptance of these approaches to countercyclical stimulus. The 2009 act, amounting to 5.5 percent of GDP, also included a variety of government spending provisions, most notably the funding of “shovel-ready” infrastructure projects and aid to state governments. And, even as signs are appearing that the recession’s end is near or already past, calls continue for the passage of yet another stimulus bill in 2009. Almost all OECD countries have introduced stimulus measures, with the packages averaging 2.5 percent of GDP across the OECD.

This fiscal policy activism is striking, given the consensus a decade ago against the use of discretionary fiscal policy as a stabilization tool. In addition to traditional concerns about policy lags that seemed confirmed by certain unfortunate policy episodes, economists had provided various theoretical arguments and some evidence suggesting that multipliers might be small and that expectations could wreak havoc not only with the strength of policy effects but also with attempts at getting the timing right. The associated exclusive focus on automatic stabilizers and the use of monetary policy seems now to have come to an abrupt halt. While the depth and duration of the recession and the unusual challenges facing monetary policy, including hitting a zero nominal interest rate constraint for all practical purposes, undoubtedly contributed to this reliance on discretionary fiscal policy, the current policy environment is in other respects hostile to activist policy. In particular, adding to government liabilities carries obvious economic risks when the medium- and long-term budget outlooks appear to be increasingly unsustainable.

In this paper, we consider the evidence on the effects of discretionary fiscal policy, paying particular attention to the current context. We begin by considering how the practice of discretionary fiscal policy has changed over time and argue that the return to activist policy predated the current recession. We then turn to the evidence on the effects of discretionary policy on economic activity, considering the variety of approaches found in the literature, including direct econometric tests of the impact of stimulative policies on consumption and investment, as well as general equilibrium approaches to measuring the impact of taxes and government purchases. Finally, we look for lessons from the evidence from two important historical episodes, for the United States in the 1930s and Japan in the 1990s.

In addressing discretionary fiscal policy, we are explicitly excluding from our discussion the use of automatic stabilizers, which has been subject to much less controversy over the years than discretionary interventions. While automatic stabilizers may be an important macroeconomic policy tool, recent policy activism suggests that they will, at least in some circumstances, be viewed by policy-makers as insufficient on their own.