Multiplier Effect

Because of the developing economic crisis, I've been reading more economics blogs. My favorites are Econbrowser, hosted by Profs. Hamilton and Chinn; Macro-Man an anonymous but extremely incisive and hilarious day-trader^*; and Follow the Money by Brad Setser. Any other reader favorites?

One excellent post by Prof. Chinn has direct relevance to governmental policy initiatives to deal with the economic problems. Her post is based on work by Mark Zandi of Economy.com. The question is: given that the economy needs to be stimulated, what method of stimulation yields the largest economic benefit. The benefit here is expressed as the stimulus multiplier, which is the amount of increase in GDP per unit of stimulus. For example, if we simply gave every person in the country $1, each could go out and buy a McDonald's value menu item. But the benefit doesn't stop there because with the increased consumption, McDonald's has to hire more workers, who in turn consume more; purchase more supplies from its suppliers, who in turn hire more workers, etc. So in principle, a $1 stimulus package can have more than $1 benefit to overall production.

So which economic stimuli had the greatest benefit? The top three were:

• Temporarily Increase Food-stamps (multiplier 1.73)
• Extend Unemployment Insurance Benefits (multiplier 1.64)
• Increase Infrastructure Spending (multiplier 1.59)

The first two items have the obvious benefits of keeping people on their feet, but also provide an extra 64-73% advantage beyond the direct stimulus. Of course these benefits can only be temporary. On the other hand, the third item has the advantage of improving neglected infrastructure -- a long term "capital gain" -- while at the same time providing an extra 60% bang for our buck.

Now for the worst stimulus concepts:

• Make Bush Tax Cuts Permanent (multiplier 0.29)
• Cut Corporate Tax Rate (multiplier 0.30)
• Make Dividend Tax Cuts Permanent (multiplier 0.37)

Since these multipliers are less than unity, it means that for every dollar of tax break, the country's production actually goes down. Of course some small segment of the population may benefit from such tax cuts, but in hard economic times, it's not clear why they would deserve a benefit when the broad population and the overall economy do not. To be fair, a few of the tax cut concepts do a little bit better, most most are break-even at best.

Note that these tax cuts that are discussed most readily as the solution to the economic problems have some of the worst possible effects on the economy. In fact, a tax cut actually hinders production, compared to other stimuli. Dr. Chinn discusses some reasons this may be true.

What fascinates me is the question of whether the multipliers work in reverse. If reducing corporate taxes by $1.00 hobbles the economy by $0.70, then would raising taxes by $1.00 improve the economy by $0.30? As heretical as that sounds, it seems that while raising taxes will withdraw $1.00 from corporate coffers and hence from the economy, it enables the government to spend $1.00 on more needful and worthy areas (say, on stimuli that have a large multiplier!).

The situation is somewhat more complicated because each of the stimulus concepts have different time scales, so it would require a more delicate touch than brute force. But it would be nice if, in the political dialog about what to do next, actual economic data would be used rather than mindless rhetoric with zero substantiation.