Labs of Democracy & Today’s Fiscal Policy Debates

Here’s my latest Economix column on the labs of democracy & today’s fiscal policy debates on uncertainty, spending, and spending vs taxes:

Many of the fiercest disagreements about fiscal policy today stem from disagreements about the causes of the slow recovery – whether government-induced uncertainty and excessive spending or low aggregate demand and insufficient government spending.

Because of the economic, political and social differences between the United States and other countries, or even the altered circumstances today in comparison with past American recoveries, there may seem to be little evidence from which to project the likely outcomes of such policy choices. But as it happens, economists have increasingly been using regions within the United States as labs of democracy, measuring contrasting approaches in various states to determine both why the recovery is sluggish and what to do about it.

This regional analysis about different types of economic medicine and their effects on job creation points to some useful insights for policy makers and Congress as they struggle through another standoff on fiscal policy. The findings on the effects of government spending in hard economic times strongly suggest, for example, that cutting spending today will hurt growth and reduce job creation.

Here are a few instances in which this research approach has been fruitful.

UNCERTAINTY: In a study published this month, Atif Mian of Princeton and Amir Sufi of the University of Chicago pointed out that if uncertainty about prospective government regulation and taxes is the primary reason for the sluggish recovery, then states where policy uncertainty is high should tend to have lower job growth. Using state-level data from National Federation of Independent Businesses, however, they found almost no relationship between job growth and the share of small businesses that cite regulation and taxes as their top concern. (Rather, they found a strong correlation between weak job growth and complaints of a lack of demand.) Their results do not provide much support for idea that apprehensiveness about regulation and taxation is holding back the recovery.

FISCAL RELIEF: Gabe Chodorow-Reich of the University of California, Berkeley, and three colleagues used similar methods to investigate whether fiscal relief during the Great Recession increased employment. In an article published last August in the American Economic Journal, they looked at how much faster employment grew in states that received more fiscal support (for Medicaid because of mechanical and predetermined reasons). The findings showed that focused fiscal relief during hard times can effectively stimulate employment. An important and timely implication of this finding is that the contrary policy of cutting spending during hard times can reduce employment. Nonpartisan private forecasters, like Macroadvisers, agree – in an analysis last week of the prospective impact of the mandatory spending cuts known as sequestration, it estimated that the spending cuts due to the sequester will result in 700,000 lost jobs by the end of next year.

SPENDING CUTS VS. TAX INCREASES: Many Republicans say that spending cuts from the sequester would have a less damaging effect on the economy than increasing taxes on upper-income earners. But some of my own recent research uses regional variation to show that this belief is at odds with the evidence. I find that modestly sized tax increases on upper-income taxpayers have a negligible to small impact on job creation. These magnitudes are much smaller than those of cutting government spending in hard times, which suggests that using modest upper-income tax increases to offset some required spending cuts would help cushion the impact of the sequester on the labor market.

About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar.
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