Here's Why Government Stimulus Does Not Work

Here's why the government stimulus worked: it kept hundreds of thousands of Americans at work, at least. It added percentage points to GDP. It sent billions of dollars to unemployed and low income Americans to prop up private demand as consumption was ready to fall off a cliff.

That's my take anyway, but not everybody agrees. In fact, if my regular commenters are any indication, quite a lot of people think my interpretation of the stimulus is utter bogus. In the spirit of balance and fairness, I wanted to hear from an academic member of the anti-stimulus team, so I spoke with Don Boudreaux, professor of economics at George Mason University* and a blogger at Cafe Hayek, about the new jobs bill and the theory of Keynesian stimulus. Here's our chat:

We should probably begin with his explanation for why he thinks government stimulus doesn't work the way the Obama administration hopes. Here's Boudreaux:I'm in the camp -- it's in the minority -- that argues that stimulus is not good policy for a couple of reasons. First, money taken to spend on stimulus projects are taken from elsewhere in the economy. The second thing, the deeper problem, is what's being stimulated? For the past eight years leading up to the crash, we had a lot of economic activity that everybody understands was built on wealth that wasn't there. People were employed doing things they shouldn't have been doing. A lot of it came through the real estate sector. If the stimulus keeps people in these jobs that they shouldn't have been in to begin with, we're just delaying the day of reckoning. I want to see the economy adjust to a more sustainable growth path where people are not artificially propped up by bubbles or by stimulus, which I worry is is the case now. That said, we can debate giving unemployment assistance.

So the jobs bill: Here's a $15 billion plan to give companies who hire unemployed Americans an exemption from paying payroll taxes on those workers through the end of this year. It also provides a $1,000 tax credit to employers who keep new workers on the payroll for at least for 52 weeks. Will it work?

As you know, I'm very skeptical of the whole stimulus idea to begin with. The problem with a tax credit for hiring new workers is maybe that a lot of those workers shouldn't be hired where they're gonna be hired. I'm a tax cut kind of guy. I'm always aiming for tax cuts. If we want to get the economy back on a sustainable long run track of economic growth we don't want to bias the economy in favor of capital or labor. If we're going to have tax cuts we want them in general so firms are not biased to use capital in bias of labor. That might be good for labor in the short run. In the long run, it's not good for labor because workers wages tie closely to productivity, which is tied closely to the amount of productive capital they have to work with. So by biasing the production in favor of labor, you put more people to work today but you reduce capital and productivity, which means their compensation in the long run will be lower. These are gimmicks. I realize politically that employment is a big problem, but you can solve that problem just as well with general across the board tax cut tax credits that aren't targeted at one factor of production.

The administration is stuck with terrible unemployment, but also a $1.6 trillion deficit that's getting slammed. So let's say you were the president's Jobs Czar. You have his ear. What do you tell him?

I would say cut taxes generally.

What kind of taxes? Payroll?

I would cut payroll taxes and corporate profits taxes. By cutting the tax on corporate profits you don't bias employers toward labor. If you really are worried about the deficit being too high and you really do want to put private sector business activity back on the tracks and moving along so that more workers are hired and wages rise, you have to make it more attractive for business in general to produce more. Cutting corporate taxes does that, if you're asking me as your economic adviser to get employment going in a sustainable pro-growth way.

Would you make the cut temporary for budgetary reasons, or would you make it permanent?

If it were up to me I would eliminate the tax on corporate profits. I would make it permanent. If you announce that it will only be temporary then it won't have the stimulus effect. It'll have some, but a lot of production plans go on well beyond three years. If they're building a factory that's in operation 16 years down the road, you diminish the effect if you limit the time. I would prefer a temporary cut to no cuts. But still, a permanent tax credit to hire new workers still really biases the production decisions.

One concern here would be that you're cutting taxes dramatically on top of a significant deficit. In fact, the size of the deficit is making some budget experts call for additional taxes, like a broad based consumption tax, or value added tax (VAT), possibly in exchange for slight reductions in the income tax. What would you say to that deal?

I am very leery not so much for economic reasons, but because the income tax has been so deeply instituted into the political structure in America that I can't really imagine it being significantly scaled back. As I understand it, the idea is we'll move to a VAT and we'll get revenue from there and we'll offset revenue from the consumption tax by eliminating the tax on middle and upper class income and corporate profits. Right?

Politically, I'm skeptical that that would happen. Academically I think you can have a serious and interesting debate about the virtues of income and consumption tax. And if I had to choose between the two in a hypothetical world where the taxes are implemented with the best interests of the public in mind, I would probably go with the consumption tax. I'm sure I would, in fact.

I could imagine two years from now, if there's another terrorist attack or the recession deepens, or whatever emergency happens: whatever party's in Washington says we need more revenue and the income tax is still there, so they start using it again. People are accustomed to paying income taxes. With a VAT, it's more hidden. You walk into a store and you pay the price that's listed and it's not obvious to you what portion is tax. We won't pay attention to it in the same way there's an income tax form that you mail in in April. I'm worried that the political deal won't take place as advertised.

*Corrected.