Building in Timing

The Kennedy tax cut in the early 1960s worked just as the theorists had said it would and converted many doubters to the Keynesian "religion." A liberal dose of increased spending got the economy moving again so it seemed appropriate to reverse the process when it was time to slow down the economy.  By 1968, inflation, which was in the 1 percent range at the beginning of the decade, was exceeding 6 percent and it was time to put the brakes on the economy.  The problem facing president Johnson was that tax increases are politically unpopular, a message lost on Walter Mondale in his run for the presidency against Ronal Reagan. To make matters worse the tax increase would be viewed as necessary to offset the growth in government spending financing the unpopular Vietnam war. There was no way Johnson could propose a permanent tax increase to finance the war, so he turned to a temporary tax surcharge as the solution.  It seemed to make good political and economic sense - a one-time tax increase to defeat inflation was something the American people could live with.  

Temporary tax changes were also something Japanese policy makers believed Japan could live with.  These officials pinned their hopes on a temporary tax cut for households to jump start Japan's economy mired in a decade long recession in the 1990s. 

Unfortunately, although the political aspect of the decisions seemed to be correct, the economics in both cases turned out to be seriously flawed. What was missing was from the discussion was any mention of the timing dimension. While today we would expect a one-time tax increase to have a smaller impact on spending than a permanent increase, it was not widely recognized at that time.

To understand the situation, consider what someone would do if the government announced this year they would impose a one-time tax of $200 and compare it to what you would expect to happen if the tax increase were permanent - that every year for the rest of your life you would pay an additional $200 in taxes. The key to the answer is one's view of consumption spending, or more specifically, the relationship between income and consumption.  As Keynes' ideas were interpreted by the early practitioners, consumption today depended on income today and a change in today's income would change today's consumption. 

As we saw in the detailed treatment of aggregate demand section, some economists challenged this view and suggested that individuals tend to take a longer view when making their spending decision and attempt to spread their consumption spending out evenly over their lifetime, even if their income was unevenly distributed.  Individuals tend to make the most during their middle ages so you could expect that in their younger and older years people would 'dissave,' and during their peak years they would save.  Furthermore, individuals have a sense of what they will make over their lifetime and this is what influences their spending.  In both cases the link between current consumption and current income is weakened.  If the income change would not substantially change lifetime, or permanent income, then it would not appreciably change current spending. 

In the situation where it is a temporary tax cut, you would expect individuals to "get through" the tough year by digging into their savings and making an effort to maintain an accepted standard of living. The result is that the anticipated change in consumption spending normally expected to follow a tax change would not materialize. Only if the tax were perceived as permanent would it be likely to affect consumption spending.  Temporary taxes aimed at individuals simply will not work - a message lost on Japanese policy makers in 1997-1998 as they attempted to follow Johnson's lead and use temporary tax cuts to revitalize the Japanese economy.

The same could not be said for all taxes. A temporary tax cut to businesses could in fact work quite well if it prompts businesses to redirect their spending to take advantage of the tax cut. An example would be an investment tax credit where the government makes businesses a deal: for every $100 a business spends on investment, the government will reduce business taxes by a specified amount. If for example, the government let the businesses write off 10 percent of the costs of the investment, then spending $100,000 would lower taxes by $10,000 which would in effect lower the cost of the investment to $90,000. If the tax cut were a one-year deal, then firms would compare spending $90,000 today versus $100,000 a year from now - and some would certainly move their expenditures to take advantage of the tax cut.

There were also serious questions concerning the timeliness of discretionary fiscal and monetary policies. It should surprise no one that the effects of a policy are unlikely to be felt immediately, although this was ignored in our discussion of the multiplier despite the fact that it may take a number of months to realize the effects of the various rounds in the multiplier process. In fact there are a number of lags which must be acknowledged when we discuss the use of discretionary policy to fine-tune the economy.

First, policy officials must recognize the problem. In Diagram 1, for example, the economy heads into a recession at point A at which time the expansionary effects of an appropriate fiscal policy should be taking effect. The problem is that it takes a while for the data to "arrive." In the not so long ago past, the official definition of a recession was two consecutive quarters of output decline, so it would take a minimum of six months to recognize the problem. This recognition lag could be dealt with if economists could forecast turning points in the economy, but at that time they had no track record and it would be extremely difficult to generate the political support for an anti- recession policy for a recession that was forecast to be on its way. This was the situation faced by Alan Greenspan in early 2000 when he raised interest rates because of a fear that the economy was heading towards inflation, even though there was no evidence of inflation when he made the decision.  

Diagram 1

Then there was the discussion lag. Once there was a general awareness of a problem, the debate would shift to the appropriate action. A perfect example would be the Kennedy tax cut that was years in the making. Do we need an expansionary policy?  If we need an expansionary policy, should it be a tax cut or a spending increase?  If it should be a tax cut, should the cut go to....  It could take months or years to agree on the appropriate policy. 

Once the decision was made to design an expansionary fiscal policy, it would take time for the policy to take effect - the action lag.  It takes a while for the policy to have an impact on the economy. If expansionary monetary policy is effective at driving down interest rates, it will be a while before that decline in interest rates is translated into additional spending and employment.

The problem with these lags, as pointed out by Milton Friedman, was discretionary policy might be valid in "theory," but in "practice," it too often could turn out to be counterproductive and could exaggerate the business cycle. In Diagram 1, the expansionary impact of the policy should, in theory, take place at point A, but if it did not take effect until point B when the economy had already turned up.  The effect would have been to raise the growth trajectory. Similarly, if  the decision was made to slow down the economy at point C, but the policy did not take effect until point D, then the contractionary policy would have accentuated the downturn.

Timing is everything with discretionary macro policies, and in an imperfect, political world there were reasons to believe timing may too often be wrong. Even without discretionary policy tools, the government could still exert a stabilizing effect on the economy through the operation of automatic stabilizers. There are a number of government programs for which the level of spending tends to be countercyclical without the need for any policy changes.  Furthermore, because the spending moves opposite of the direction of the economy, the spending tends to exert a stabilizing influence on the economy. 

Unemployment benefits would be an example.  Government unemployment benefits tend to increase as a recession sets in and these increased benefits tend to soften the decline in income and consumption. The same would be true with the income tax. As the economy expands and individuals' earnings expand, so will their taxes which should act as a brake on their spending. In neither case was there any need to make any explicit policy decisions to alter the net flow of spending originating in the government sector.  Right on queue, the government would inject increased spending in the form of unemployment into the economy as people began to be laid off. As the economy began to expand, some of the additional income earned by those returning to work would be drained off in the form of higher taxes - precisely the slowing of spending which the Keynesian model would have proposed. 

The 1960s taught us that timing could not be ignored, and it prompted Keynesian economists to extend their analysis to incorporate time. One of the extensions was into the area of economic forecasting models. If you accept the fact that policy lags exist, then there will be a need to anticipate turning points in the economy. You will need to be able to implement expansionary policies today that will take effect in the future just as the economy turns downward. Before leaving our discussion of short-term fluctuations and moving to a discussion of long-term economic growth, we will look briefly at economic forecasting models.