The Best Form of Economic Stimulus?

Interesting post by David Blanchflower about the best form of economic stimulus – Here’s a way to end the slump (Useful for any economic student wishing to understand marginal propensity to consume – mpc)

Ford model T

An economic stimulus in 1936 increased demand for model T Fords

A fiscal stimulus could involve a tax cut or government spending increase. This should increase overall aggregate demand, and boost economic growth.

A monetary stimulus could involve interest rate cut or policy of quantitative easing.

But, if we decide to pursue fiscal stimulus  – How do we make sure this has the biggest effect on increasing overall aggregate demand? Who is the best group of people to give it to?

For example, If you cut the higher rate of marginal income tax 50p to 40p for incomes over £100,000 – then this tax cuts is most likely to be saved. This is because people with salaries of over £100,000 are not in great need of buying essential items. They probably have most items they need. If they gain an extra increase in income, a large proportion will just be saved. They may buy one or two extra luxuries, but comparatively, they  will have a low marginal propensity to consume. Therefore, the effect of the fiscal stimulus will be largely dissipated. You could argue that a low income tax may have a supply side incentive, but at 50%, it is debatable how significant this will be.

If you cut capital gains tax, it would benefit a relatively small percentage of wealthy firms and individuals. Again, you would expect a relatively low marginal propensity to consume. There may be some extra investment. But, in the current climate, you would expect business to be risk-averse. It’s hard to see businessmen rushing to invest because of lower capital gains tax.

Quantitative easing is a form of monetary policy which has given extra cash reserves to banks. Yet, this has had a very limited stimulus effect. Basically, banks have been saying thanks very much for the cash, we will use it to improve our bank reserves, but not to engage in risky investment.

What about if we gave it to those on very low income. For example, low paid workers, who have seen a 10% real pay decrease in past few year? or increase unemployment benefits? Here, you would expect a higher marginal propensity to consume. The problem is that increasing benefits to the unemployed, is not going to gain you too much political kudos.

In 1936, the US government gave a stimulus to a group of low income people – military veterans from the First World War. The US Congress authorised $1.8bn to 3.2 million war veterans (2.1% of GDP) = (to put stimulus into perspective – 2.1% of GDP is equal to £30bn in UK). The money was financed from a bigger government deficit.

Joshua Hausman from UC Berkeley argues that the bonus added 2.5 to 3 percentage points to 1936 GDP growth and lowered the unemployment rate by 1.3 to 1.5 percentage points. Contemporary newspaper accounts reported that veterans were keen to spend this extra money. Many used the $550 + payment to buy their first ever car. Fortunately, the price of the cheapest Ford car was $500.

The LA Times wrote “All signs yesterday pointed to a real spending spree by veterans”

The Veterans association estimated that for every dollar a veteran gained, they spent 70 cents. (A mpc of 0.7). That is a high % of extra income to be spent.

If we assume that there really was a marginal propensity to consume of 0.7 (And for simplicity let us ignore import spending and taxes) This would mean the veteran stimulus would create a multiplier effect of 3.33 Multiplier = 1 /( 1-mpc) This means that for the extra government spending of $1.8. The final increase in GDP would be $5.94bn. If the government had cut taxes for the wealth, the impact of the stimulus would have been much lower.

What should the UK do?

The irony is that the most effective stimulus might be to increase welfare benefits. People on benefits are typically, the lowest income groups. If benefits are increased, the marginal propensity to consumer might be highest. However, this isn’t going to happen, the government are more likely to cut benefits. The government may also claim that increasing benefits may create a disincentive to work.

In terms of tax cuts, increasing the threshold for income tax, will benefit everyone, but the lowest paid relatively the most. This also increases the incentive to work. It would be a good place to start.

Alternatively, the government could send out a pay cheque of £500 to 1 million deserving people, with a proviso this pay cheque has to be spent in the next two months. Who could those 1 million deserving people be. Well, you we could start with teachers and nurses. I would happily volunteer to have a marginal propensity to consume of 100%. I’m sure a few students would be similarly willing.

 

The final point is that in a recession, the multiplier effect tends to be larger than during high growth. This is because there is spare capacity, and in the recession, people have cut back on spending, waiting for income to increase. (Fiscal multiplier and Europe)

 

Joshua K. Hausman (2013), ‘Fiscal Policy and Economic Recovery: The Case of the 1936 Veterans’ Bonus,’ University of California, Berkeley.

4 Responses to The Best Form of Economic Stimulus?

  1. Jo February 4, 2013 at 10:57 am #

    I used to admire Blanchflower but not so much recently. He just seems to pimp for the British Labour Party on twitter 24/7.

    ….which is sad.

  2. Bill Martin February 5, 2013 at 8:18 am #

    As a layman I find your articles on various economics topics enlightning. However as a British citizen now living in Florida I find that the British government economic policy is very stupid. No wonder I am reading in the papers about triple dip recession. If the government wants to boost the economy they have to deal with first the working class/middle income people. If you are going to cut spending which they have done massively then you have to cut taxes massively as well. They need to cut VAT by 50% to bring it down to 10%, petrol taxes by at half and a cut in payroll taxes as well. Yes I know the deficit will go sky high straight out to the stratosphere however that is temporarily. With the huge amount of cash in private hands especially low income people they are going to spend the money and increase as you would say an aggregate demand. With the AD up then then they can add the Quantitative Easing, lower the interest rates. With these policies in place they will be a greater demand on goods and services and as you know jobs are created and that is a positive impact on the UK. What do you think?

    • Tejvan Pettinger February 5, 2013 at 9:10 am #

      I think VAT rate of 10% would be too extreme and too expensive. Even a modest cut of 2% would add significantly to consumer spending. But, in a recession, the government should be willing to provide sufficient stimulus until the economy recovers, then they can concentrate on reducing the deficit.

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