Three Keys to Effective Fiscal Stimulus

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The following articles appeared in a variety of publications this year. Some refer to fiscal
policy at the beginning of the year and some to possibilities for new policy now. There
are a number of questions at the end of the articles to help you focus on key issues.
These questions are for your own benefit and you will not be expected to hand in written
answers.

                         Three Keys to Effective Fiscal Stimulus
Douglas W. Elmendorf, Senior Fellow, Economic Studies
Jason Furman, Senior Fellow, Economic Studies
BROOKINGS INSTITUTION, JANUARY 26, 2008 —

Policy-makers and economists from a variety of perspectives have rapidly coalesced around agreement on
three economic issues. First, a spate of bad news, including a jump in the unemployment rate, a decline in
consumer spending and a plunge in housing starts, leave little doubt that the economy is weakening.
Second, well-designed fiscal stimulus, in the form of increased government spending or tax reductions, has
the potential to help cushion the economic blow. Finally, most agree that any well-designed stimulus
should be timely, temporary and targeted – the "three T" principles enunciated by economists as diverse as
Lawrence Summers, Martin Feldstein, and Federal Reserve Chairman Ben Bernanke and accepted by
leaders from both political parties.

The three Ts are important because fiscal policy can only play a supporting role in curbing economic
troubles, and the principles are critical to ensure that any benefits do not come at the expense of serious
long-run harm. The Federal Reserve is capable of acting quickly and dramatically to stabilize the economy,
as evidenced by its recent 75 basis point cut in the federal funds rate. But the Fed faces one major
limitation: it takes about a year for its interest rate moves to have a major effect on economic output and
jobs. While the recent round of interest rate cuts will have some effect on the economy this year, we
probably will not see the full impact on the aggregate economy until 2009.

The rapidly evolving downturn provides a motivation for timely fiscal stimulus which, if well designed,
could raise economic output and create jobs by the middle of 2008. It also provides a motivation for
keeping fiscal stimulus temporary. Based on current forecasts, the economy does not need a boost in 2009.
If Congress and the president give it one, then the Federal Reserve is likely to offset the fiscal stimulus by
not cutting interest rates as much as it would otherwise have. In addition, helping with our short-term
weakness should not unnecessarily toll our long-term budget deficit.

Any steps that policy-makers take must be targeted for two senses: helping those who most need to be
protected from the downturn and achieving the maximum bang-for-the-buck in added output for a given
budgetary cost. Fortunately, these are complementary, as the households most in need of money are also
the families most likely to spend it —thus boosting aggregate economic activity.

We recommend three measures as most suitable to the task. One is a temporary increase in food stamps, a
step that could be implemented quickly through electronic debit cards and would go to families likely to
spend much or all of the money. A second is a temporary extension of unemployment benefits, reflecting
the fact that the long-term unemployment rate is already nearly double what it was going in to the last
recession, may well rise further in coming months, and the unemployed will spend a very large fraction of
these benefits. To reach the broadest group, the third and largest step we urge is a temporary, one-time
refundable rebate aimed at all working households.

Some other measures do less well in meeting the goals of the three Ts. For instance, limiting rebates only to
households that pay income taxes, a step reportedly under consideration by the Bush administration, would
ignore many hard workers, like the more than 25 million households who pay payroll taxes but do not earn
enough to pay income taxes. Plus, another 20 million working households who pay relatively low-income

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taxes would get only a limited rebate, not the full amount. This undermines the fairness of the plan, and
would also reduce its overall effectiveness by denying payments to families most likely to spend them.
Analysis by Mark Zandi of Moody’s Economy.com, for example, finds that rebates would be 24 percent
more effective at stimulating the economy if they were made refundable for low-income households.

Temporary tax breaks to encourage business investment may not be much of a panacea either. Such a
measure was not very successful when it was employed in the last slowdown because it is hard for
businesses to turn on a dime with complicated investment decisions. The end result is that much of the cost
of the proposal would simply reward existing investment.

Three simple principles on which policy-makers agree. Now, let's apply those principles to ensure that any
actual legislation is timely, temporary, and targeted.

Wall Street Journal. July 30, 2008

        The 2008 Economic Stimulus: First Take on Consumer Response
Some studies on the 2001 economic stimulus package took more than three years to be released. The first
one measuring effects of the 2008 package is out within three months.

In a new study, business school professors Christian Broda of the University of Chicago and Jonathan
Parker of Northwestern University conclude the stimulus payments “are providing a substantial stimulus to
the national economy, helping to ameliorate the ongoing 2008 downturn.” U.S. households are “doing a
significant amount of extra spending” because of the $90 billion in government payments that have gone
out so far, they say.

Source: The Impact of the 2008 Tax Rebates on Consumer Spending: Preliminary Evidence

As outlined in The Wall Street Journal today, the preliminary assessment found that the typical family
increased its spending on food, mass merchandise and drug products by 3.5% once the rebates arrived

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relative to a family that hadn’t received its rebate yet. The average family spent about 20% of its rebate in
the first month after receipt, a slightly faster pace than with the 2001 rebates.

The authors estimate that nondurable consumption — a piece of consumer spending that excludes big-
ticket items such as refrigerators and televisions — rose by 2.4% in the second quarter as a direct result of
the stimulus payments. It’ll be boosted by 4.1% in the current quarter, they estimate. (Nondurable
consumption accounted for about 21% of the nation’s total economic output, or GDP, last year.)

Consumer surveys would be the most common way to measure response to the stimulus. The risk:
Consumers may not actually do what they say they’re doing. (People might like to think they’re saving up,
for instance, even if they aren’t.) So the authors used an alternate route: With funding from a foundation
and their universities, they purchased data collected by ACNielsen, the research firm best known for its
television and radio audience ratings. ACNielsen’s Homescan program collects data by having consumers
in its panel scan the barcodes of products they bring home from the store. (The database provides
information on spending largely at grocery stores, drugstores and mass-merchandise outlets.) Follow-up
surveys of the consumers determine when they received their stimulus payments, based on the
government’s largely random approach tied to Social Security numbers.

Durable goods (appliances, electronics, furniture and other big-ticket items) couldn’t be included in a study
of this kind because, among less than 34,000 households, they wouldn’t be purchased regularly enough to
draw meaningful statistical conclusions.

But the follow-up survey of consumers did ask about spending patterns, and durables had a strong showing.
Households on average said they upped their spending on clothing and food by $92 combined due to the
tax rebate. But entertainment spending rose by $87 and spending on durables increased by $91. The “other”
category showed $178 in additional spending per household.

Among other conclusions in the study:

    Low-income and low-asset households increased their spending at almost double the rate of the average
household.
    Shoppers are spending a higher share of their rebate in “supercenters” such as Wal-Mart and Target
relative to their usual behavior.
    People in greater Los Angeles and in the Southeast region of the U.S. are spending more than people in
other major metro areas. (In L.A., the response is about 30% larger than the response in the average area.)
    The week in which a rebate is received shows the highest effect, with weekly spending increasing 6%
on average during the first week. But anticipation of a rebate check seems to do little: the authors find no
impact on spending in the weeks prior to receiving the rebate.

In 2005, Mr. Parker co-authored a study based on extensive household surveys and concluded that
recipients of the summer 2001 stimulus checks spent a third of the money within two months and another
third in the three months after that. The payments appear to have helped to pull the economy out of that
eight-month recession, which ended in November 2001.

Worries about the possibility of a 2008 recession led Congress to rush through its $168 billion economic
stimulus package, with more than $100 billion in direct payments to consumers. With recession fears still
looming, many Democrats are calling for a second stimulus package that would take effect by the end of
the year or early next year as the first stimulus fades. – Sudeep Reddy

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                        Main Street Needs a New Stimulus
Martin Neil Baily, Senior Fellow, Economic Studies . Brookings Institution
OCTOBER 21, 2008 —

Main Street economies across the nation are headed in the wrong direction, with homes foreclosed, jobs
lost and production down. We are now in a recession and the only question is how deep it will be. A new
fiscal stimulus package would, by redirecting spending and employment, prevent the U.S. economy from
trending further into the danger zone.

How large should the stimulus package be? Given the uncertainty involved, I recommend an immediate
stimulus package of $200 billion, with preparation of an additional $100 billion to be triggered if
unemployment goes over 7.5 percent.

Every taxpayer should be concerned about how this additional spending-on top of the $700 billion bailout
package-will further contribute to the budget deficit. If the economy goes into a severe recession, however,
tax revenues will fall sharply and the impact on the budget deficit will likely be even worse than the impact
of the fiscal stimulus.

In short, even if a stimulus package creates a net cost to the deficit, that cost is worthwhile to avoid the
damage of a severe recession.

What form should the stimulus package take? First, if the American economy is to move to a sustainable
recovery, the housing market has to stabilize. The terms of the new rescue package allow for the purchase
of mortgages as well as mortgage-backed assets. I would urge additional funds for families facing default.
Enabling families to move into 30-year fixed rate mortgages through Fannie Mae and Freddie Mac at a rate
of interest between 5 and 6 percent is an attractive approach to providing this assistance.

It is vital that a stimulus package work quickly and provide as much boost to spending as possible. If this
were done soon, the IRS could use the same taxpayer list that was used earlier this year and the money
would be released this fall.

Attention should also be directed to the nation's infrastructure, especially crumbling roads that need repair
and neglected bridges that may collapse. Looking after the existing infrastructure is not as exciting as
cutting ribbons on new projects, but it could generate jobs quickly and meet an important need.

States and localities are feeling tremendous budget pressures because of the weak economy and the decline
in property tax revenue. For starters, infrastructure projects with state and local jurisdictions should not be
cancelled because of the short-term budget pressures. Sustaining such projects would, among other things,
help avoid job layoffs.

But even more aid should be given to states and localities, which face tougher budget limitations than the
federal government. For example, budget assistance could be targeted to states with high unemployment
and mortgage default rates, especially to sustain Medicaid spending. Some states, such as California, are
finding it difficult or impossible to sustain support for health care because of budget pressures.

Another stimulus approach is assistance for unemployment insurance. This program has traditionally been
a backstop for the economy, serving as an important automatic stabilizer. With the job situation
deteriorating, there are many workers reaching the point where benefits are exhausted and it would make
sense to extend the duration.

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Some business tax changes may also be necessary to obtain wide support for a stimulus package. Capital
gains taxes are already low. I would urge that we wait and examine the idea of broadening the base of
corporate tax and lowering the rate in the context of a larger tax reform package.

The American economy is in trouble and the balance of risks strongly favors a substantial fiscal stimulus.
Congress and the White House should act soon to ensure that Main Street America continues to be a great
place to live, work and produce.

    Wall Street Journal, OCTOBER 31, 2008

                            Japan Unveils $51.5 Billion Stimulus

By HI ROKO TA BUCHI

TOKYO -- Japanese Prime Minister Taro Aso unveiled a stimulus package with five trillion yen ($51.5
billion) in new government spending to buttress Japan's economy against the fallout from the global
financial crisis.

Japanese Prime Minister Aso will delay elections, citing the financial crisis

Mr. Aso also ruled out snap elections, saying steps to address the weakening economy should take
precedence over politics. He had previously been expected to call a vote as early as October.

"The economy is experiencing a
once-in-a-century storm," Mr. Aso
said at a nationally televised news
conference. "Protecting livelihoods
should come first."

Mr. Aso spoke as investors were
cheered by a rally that sent the Nikkei
stock index up 10% to 9029.76 for
the third straight day of gains, buoyed
by a respite in the soaring yen that
hurts the nation's flagship exporters.
Still, the index has lost 30% in the
past month, hitting a 26-year low just
days ago.

The stimulus package is the country's
second in two months, and follows
similar moves by governments world-
wide. Japan, which economists say
faces a steep recession, announced a
set of stimulus steps in August with
about 1.8 trillion yen in new spending
to tackle high energy and material costs. The Bank of Japan is also considering a cut in Japan's already low
interest rates for the first time in seven years.

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Economists question whether Japan will be able to spend its way out of the economic slowdown. Many
predict that the latest measures will lift Japan's gross domestic product by only 0.2 to 0.3 percentage point.
They also said the government will need to follow up with more stimulus measures to carry Japan through
a period of economic contraction.

"Mr. Aso is putting the shutters down, but the storm is so strong it could blow the windows out," said
Masaaki Kanno, chief economist at J.P. Morgan Chase & Co. in Tokyo.

Mr. Kanno said a proposed two trillion yen payout to families, a centerpiece of the package, wouldn't
significantly spur consumption because Japan's thrifty consumers will only save that money. A similar
scheme in the U.S. earlier didn't significantly lift spending.

Mr. Aso, whose two predecessors resigned after just a year each in office, attempted Thursday to assert
strong leadership. He brushed off questions about when he would call elections.

He called the stimulus measures speedy and targeted. On top of the payouts, the package includes expanded
tax relief on housing loans, tax reductions for small businesses, and a reduction in highway tolls. Mr. Aso
said he will seek to revive legislation allowing the government to inject funds into banks, a move that
facilitates loans to small firms. The package calls for the purchase of shares held by the country's banks to
bolster their balance sheets.

Japan's banks, relatively unscathed previously, have been hurt in the recent selloff, leading to profit
warnings and efforts to raise capital. Thursday, Moody's Investors Service warned that Japan's banks have
"now been drawn fully into the global credit crunch."

                                Discussion questions about the articles.
                  Think about the explanations of why your answers may be accurate.

1. In a serious fall in real GDP and employment, which of the following change in federal budgets is likely
to have the largest effect on total spending in the economy in the near future? A. $100 billion increase in
unemployment compensation benefits. B. $100 billion increase in spending on highways and bridges. C.
$100 billion decrease in income taxes. D. $100 decrease in capital gains taxes. E. $100 increase in
payments to state governments to replace falling revenues. Why?

2. Which is more likely to have a fiscal stimulus in the near future? A tax cut on individuals earning
$20,000 per year or a tax cut on individuals earning $100,000 per year? Why?

3. If fiscal policy is being used to slow the growth in spending, which of the following would be the most
powerful in the short run? An increase in taxes on interest income? An equal increase in taxes on high-
income individuals? An equal increase in taxes on low-income individuals? Why?

4. Which has a more powerful effect on spending in the economy this year? A temporary increase in taxes
lasting one year? A permanent increase in taxes lasting over the next 10 years? Explain why?

5. Should we wait to pass any stimulus packages until the new administration is in office? Why or why
not?

6. Why should we use fiscal stimulus as opposed to monetary policy stimulus? Or should we?