A set of Fiscal Policy tools = 100 bps rate cut

Minneapolis Fed chief, Narayana Kocherlakota in this speech points to results of an interesting research done by his Fed economists.

He says given the eco situation, he would prefer to cut rates further. But with rates at zero bound, could there be other options? We know there are many unconventional/non traditional measures. But what about fiscal policy?

He says three changes in tax policy will help deliver a stimulus equal to 100 bps policy rate cut.

Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative. Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.

In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay.3 The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut.

The overall logic is like this.

  • You need people to consume and invest more today. So you need to increase both C and I in GDP.
  • Permanent consumption tax in 2012 leads to people preferring consumption in 2010 and 2011. This leads to rise in consumption today.
  • Now as people could adjust labor income today factoring rise in consumption  tax in 2012. Hence you need cut in labor income tax.
  • As people could lower consumption in 2012, investment might lower in 2011. Hence you need a temporary investment tax credit.

What will be the impact on public finances? We have two tax rate cuts and one rise in tax:

I’ll make two additional comments about this plan. First, how much would this three-pronged change in taxes cost the American taxpayer? The exact answer to this question would depend on a host of details—details that many of you know a lot more about than I do. But let me offer a very rough calculation. Annual consumption is about $10 trillion, and annual labor income is about $8 trillion. I’ve sketched a plan that involves increasing the tax rate on consumption by 1 percentage point and lowering labor income taxes by 1 percentage point. So, the first two parts of the plan would add about $20 billion per year to government revenue beginning in 2012.

The plan also involves an appropriately sized investment tax credit. Private gross investment is about $2 trillion. To offset the effect of the consumption tax in 2012, the fiscal authority needs to provide a 1 percent subsidy to this entire amount. Hence, the investment tax credit involves a one-time cost in 2012 of $20 billion. These calculations, while obviously very rough, do indicate that the plan has the potential to be fiscally responsible.4

Second, I’ve not discussed distributional considerations. Raising consumption taxes by 1 percentage point and lowering labor income taxes by 1 percentage point for all Americans would tend to redistribute the burden of taxes toward lower-income citizens. For this reason, I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.

The research points to some exciting similarities between fiscal and monetary policy:

Overall, I believe that this analysis has both policy and intellectual aspects. From a policy point of view, I’ve deliberately focused on a rather narrow aspect of fiscal policy—namely, how it can be used to mimic monetary policy. That narrow focus seems appropriate to me, given my role in the policy process. I find the resultant policy to be attractive because may be able to generate macroeconomic stimulus without increasing the deficit.

From an intellectual point of view, the analysis demonstrates the remarkable power of public finance in addressing important macroeconomic questions. Of course, this last lesson is hardly new. As I mentioned at the beginning of my talk, over the past 30 years, macroeconomists have used the tools and methods of public finance to address a host of important questions, ranging from optimal stabilization policy to optimal unemployment insurance. I’m proud to say that a great deal of that work has been done at the Federal Reserve Bank of Minneapolis.

I am yet to read the paper. It looks highly technical. It would have been more interesting to see some practical application than just a model.

Anyways, I was more excited to read how fiscal policy can deliver the same impact as monetary policy. This crisis has led to many downfalls and many rises of economic ideas. Fiscal policy definitely falls in the latter club. From being considered as a no policy to being seen in line with monetary policy is exciting stuff.

Just a few days ago Bernanke said that in conventional and unconventional monetary policy the goals and transmission mechanisms are very similar. Both try and lower interest rates. And now we have this new research saying that through policy design both fiscal and monetary policy can deliver similar impact.

Another interesting bit is Kocherlakota changing his earlier stance from preferring to sit on sidelines (and thus coming across as a hawk) to wanting do something to resurrect the US economy (and thus changing to a dove).

But more than this it is this nice research idea the speech points to.

One Response to “A set of Fiscal Policy tools = 100 bps rate cut”

  1. Tweets that mention A set of Fiscal Policy tools = 100 bps rate cut « Mostly Economics -- Topsy.com Says:

    […] This post was mentioned on Twitter by tom serona, Rahul Deodhar. Rahul Deodhar said: A set of Fiscal Policy tools = 100 bps rate cut http://goo.gl/fb/xzLd3 […]

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