Which is more effective as a fiscal stimulus: government spending or tax cuts?

"The Economic Impact of the American Recovery and Reinvestment Act" is a January 21, 2009 report by Mark Zandi that analyzes the effect of the federal government program of tax cuts and increased spending designed to stimulate the sluggish U.S. economy. According to the 18-page report:

The fiscal stimulus plan proposed by the House Democrats includes a reasonably designed mix of government spending increases and tax cuts. The spending increases total about $550 billion in 2009-2010, and there are $275 billion in tax cuts. While the timing has yet to be determined, the tax cuts are expected to occur largely this year and much of the spending would begin in 2010.

Increased government spending provides a large economic bang for the buck and thus significantly boosts the economy. The benefits begin as soon as the money is disbursed and are less likely than tax cuts to be diluted by an increase in imports. The most effective proposals included in the House stimulus plan are extending unemployment insurance benefits, expanding the food stamp program, and increasing aid to state and local governments. Increasing infrastructure spending will also greatly boost the economy, particularly as the current downturn is expected to last for an extended period. Most of the infrastructure money will be spent on hiring workers and on materials and equipment produced domestically.

Tax cuts generally provide less of an economic boost, particularly if they are temporary; on the other hand they can be implemented quickly. A particular plus for individual tax cuts included in the House stimulus plan such as the payroll tax and earned income tax credits is that they are targeted to benefit lower- and middle-income households that are more likely to spend the extra cash quickly. Investment and job tax benefits for businesses are less economically effective, but are not very costly and more widely distribute the benefits of the stimulus plan.

Income support

The House stimulus plan includes some $100 billion over two years in income support for those households under significant financial pressure. This includes extra benefits for workers who exhaust their regular 26 weeks of unemployment insurance (UI) benefits; expanded food stamp payments; and help meeting COBRA payments for unemployed workers trying to hold onto their health insurance.

Increased income support has been part of the federal response to most recessions, and for good reason: It is the most efficient way to prime the economy's pump. Simulations of the Moody’s Economy.com macroeconomic model show that every dollar spent on UI benefits generates an estimated $1.63 in near-term GDP.x Boosting food stamp payments by $1 increases GDP by $1.73 (see Table 2). People who receive these benefits are hard pressed and will spend any financial aid they receive very quickly.

Table 2: Fiscal Stimulus Bang for the Buck
Source: Moody's Economy.com

Tax Cuts
Non-refundable Lump-Sum Tax Rebate 1.01
Refundable Lump-Sum Tax Rebate 1.22

Temporary Tax Cuts
Payroll Tax Holiday 1.28
Across the Board Tax Cut 1.03
Accelerated Depreciation 0.25

Permanent Tax Cuts
Extend Alternative Minimum Tax Patch 0.49
Make Bush Income Tax Cuts Permanent 0.31
Make Dividend and Capital Gains Tax Cuts Permanent 0.38
Cut in Corporate Tax Rate 0.30

Spending Increases
Extending Unemployment Insurance Benefits 1.63
Temporary Increase in Food Stamps 1.73
General Aid to State Governments 1.38
Increased Infrastructure Spending 1.59

Note: The bang for the buck is estimated by the one year $ change in GDP for a given $ reduction in federal tax revenue or increase in spending

Another advantage is that these programs are already operating and can quickly deliver a benefit increase to recipients. The virtue of extending UI benefits goes beyond simply providing aid for the jobless to more broadly shoring up household confidence. Nothing is more psychologically debilitating, even to those still employed, than watching unemployed friends and relatives lose their sources of support.xi Increasing food stamp benefits has the added virtue of helping people ineligible for UI such as part-time workers.

x
The model is a large-scale econometric model of the U.S. economy. A detailed description of the model is available upon request.
xi
The slump in consumer confidence after the recession in 1990-1991 may have been due in part to the first Bush administration’s initial opposition to extending UI benefits for hundreds of thousands of workers. The administration ultimately acceded and benefits were extended, but only after confidence waned and the fledgling recovery sputtered.