Relative Effectiveness of Direct Government Spending to Rebate Checks or Tax Cuts Needs to Be Put in Perspective

February 10, 2009

So today, I was reading this report from the CBPP, which actually makes some good arguments against some of the not-so-good provisions of the Senate bill (such as the tax breaks for car buyers and home buyers). But the paper begins by making this statement that sounds nice, but needs to be put in the proper perspective:

Well-designed spending measures tend to be significantly more effective than tax cuts in stimulating aggregate demand because much of tax cuts are saved rather than spent.

So direct government spending will boost aggregate demand greater than tax cuts. That is true in the short-run under certain assumptions, but it overlooks a fundamental principle that students of principles of macroeconomics learn: GDP isn’t a perfect measure of economic well-being, nor is it necessarily a perfect measure of how much “stuff” is actually being “produced.”

When calculating GDP, the Bureau of Economic Analysis includes government spending as adding directly to GDP (except for transfer payments), regardless of how much it enhances true wealth. So for example, if the government paid people to dig ditches and others to fill them back up, BEA would count that work as adding to GDP as part of some service government is providing to the country. The reality though is that everyone would basically be better off if the government just wrote those workers a check (or a tax cut) instead and they got to sit at home watching The Price Is Right instead of having to go through with the disutility associated with hard labor. Their work (using the factors of production) is pointless, and the extent to which it really stimulates the economy is really no different than writing them a check. So in the end, it’s all just a measurement question.

BEA doesn’t count transfers as directly adding to GDP. Nor would it count a rebate check or a tax cut as adding to GDP directly. But it would count as adding to GDP any government spending that had the exact same end distribution of income to the “factors of production,” even if that production isn’t worth a dime. This is obviously a problem.

The moral of the story is that before we ask ourselves how best we can grow GDP in the short-run, we have to ask ourselves, is growing GDP given how we measure it really how we should be judging economic well-being in the short-run?

(On a side note: A common topic of conversation that we have internally at the Tax Foundation is whether BEA should count transfers as really adding to GDP if one believes that such transfers have a value added for society, such as promoting social harmony, less violence in the streets, or some feeling of goodwill that has value for some in society. The recipients of those transfers, like welfare recipients or Social Security recipients, would essentially be the producers of those services by their mere acts of cashing the checks. If having a welfare program lowers crime rates, then there is some implicit public safety being produced here that people would be willing to pay for, and it would be counted if police had to be hired to produce that same level of public safety.)


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