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Brooks Wilson's Economics Blog: Barro and Redlick on Multipliers

Thursday, October 1, 2009

Barro and Redlick on Multipliers

The financial crisis that deepened in September 2008 re-ignited a debate about the efficacy of fiscal stimulus.  Robert Barro, a professor of economics at Harvard, and Charles Redlick, a graduate of Harvard add to our knowledge that they describe as "thin" in their Wall Street Journal article, "Stimulus Spending Doesn't Work."  The article summarizes their recently completed research published by the National Bureau of Economic Research.  They divided fiscal policy into three types: war induced spending, peacetime spending, and tax cuts.  On war spending, they write 
For annual data that start in 1939 or earlier (and, thereby, include World War II), the defense-spending multiplier that applies at the average unemployment rate of 5.6% is in a range of 0.6-0.7. A multiplier less than one means that, overall, other components of GDP fell when defense spending rose. Empirically, our research shows that most of the fall was in private investment, with personal consumer expenditure changing little.

Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12%.
In a weak economy, with unemployment exceeding 12%, war spending might help the economy if you don't suffer high casualties and a country's physical capital remains intact.  For my students, that reads like something that I wrote here.  Thankfully, our economy was not quite that weak, but that means that the stimulus hurt a little.Barro and Redlick assert that economists have reversed causality of the impact of peacetime spending on GDP.  Spending does not increase GDP, but GDP growth does increase spending. 
To evaluate typical fiscal-stimulus packages, however, nondefense government spending multipliers are more important. Estimating these multipliers convincingly from U.S. time series is problematical, however, because the movements in nondefense government purchases (dominated since the 1960s by state and local outlays) are closely intertwined with the business cycle. Thus the explanation for much of the positive association between nondefense spending and GDP is that government spending increased in response to growing GDP, rather than the reverse.
The authors find that tax cuts are good, but the results may not be robust.
The effects of tax rates on GDP growth can be analyzed from a time series we've constructed on average marginal income-tax rates from federal and state income taxes and the Social Security payroll tax. Since 1950, the largest declines in the average marginal rate from the federal individual income tax occurred under Ronald Reagan (to 21.8% in 1988 from 25.9% in 1986 and to 25.6% in 1983 from 29.4% in 1981), George W. Bush (to 21.1% in 2003 from 24.7% in 2000), and Kennedy-Johnson (to 21.2% in 1965 from 24.7% in 1963). Tax rates rose particularly during the Korean War, the 1970s and the 1990s. The average marginal tax rate from Social Security (including payments from employees, employers and the self-employed) expanded to 10.8% in 1991 from 2.2% in 1971 and then remained reasonably stable.

For data that start in 1950, we estimate that a one-percentage-point cut in the average marginal tax rate raises the following year's GDP growth rate by around 0.6% per year. However, this effect is harder to pin down over longer periods that include the world wars and the Great Depression.
Barro and Redlick conclude,
The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP.

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