The era of bipartisanship that began on Sept. 11 may not be over, but it is already showing signs of wear. Although Republicans and Democrats are joined at the hip on issues directly related to the war effort and relief, they remain divided on others. In particular, the question of what form an economic stimulus package ought to take has polarized the two parties.
In general, Democrats favor additional spending, while Republicans favor tax cuts in order to stimulate growth. The conventional wisdom is that each party is simply appealing to its base. But in fact, there is a serious question involved about exactly how government stimulate can the economy.
Historically, economists have viewed tax policies as less stimulative in the short-term. The most important effects of tax policy are on labor supply, saving, investment and productivity, and generally require a longer time frame to have a significant economic impact. Thus, economists have tended to favor spending for short-run stimulus. Public works, public service jobs programs and the like were thought to impact growth more quickly, and theoretically could be targeted better at the source of a slowdown.
In reality, it is a fallacy to think that spending works better, even in the short-run, than tax cuts. The reason is that spending programs require far longer lead time than most people realize, and it is much harder in practice to target spending to where it would do the most good.
Consider public works. These have been used to counteract economic downturns for many years. In theory, increased demand for steel, concrete and workers will create a ripple effect on growth. The problem is that the government cannot write a check today and start building tomorrow. Plans have to be drawn up and environmental impact studies done, and someone has to decide which projects to build from an almost infinite number perpetually advocated by members of Congress, federal agencies, and state and local governments. This all takes far more time than anticipated by those who advocate spending for short-run economic stimulus.
Then there is the problem of targeting. It is very seldom the case that the places where public works projects are needed are the same places where unemployment is high. It is also highly unlikely that very many of those unemployed in a given area have the specialized construction skills necessary to do the work.
For these and other reasons, spending is actually the least effective way to stimulate growth quickly. Any spending program enacted now, in the expectation that it will provide short-run stimulus, probably won't be effective until long after the economy has recovered on its own. At that point, it is possible that the stimulus will be viewed as inflationary, leading the Federal Reserve to raise interest rates.
The failure of countercyclical public works programs in the 1970s led most economists to conclude that fiscal "fine-tuning" just doesn't work. They now believe that the Fed is better suited to countercyclical policy, because monetary policy can be changed almost at a moment's notice. However, even Fed policy affects the economy only with a considerable lag. The Fed has been easing monetary policy aggressively since January, with no discernable effect on economic growth.
If government spending and monetary policy are both largely ineffective in the short-run, what is there left to do? It may be time to revisit tax policy. Its bad reputation among economists as a fiscal stabilizer may be due more to the fact that it has not been used properly, rather than because it is inherently ineffective. In the past, tax rebates have been the principal way tax cuts have been used for short-run stimulus. But they don't work because they don't change incentives for work, saving or investment, and because the overwhelming majority of people save them rather than spend them.
However, tax cuts targeted at investment could have immediate stimulus. Businesses always have investment plans ready to go as soon as the time is right. If they could write off new investments more quickly, through shorter depreciation schedules, they would begin to act the minute they were certain the legislation would pass. And because the benefits only accrue to businesses making new investments in productive plant and equipment, it would stimulate growth in both the long run and the short run.
The truth is that cutting taxes for businesses is probably the ONLY thing the government can do that actually will stimulate economic growth in the near term.