UC San Diego Economist Shows Spending is More Valuable Than Tax Cuts

Barry Jagoda | February 2, 2009

At a time when the House of Representatives passed a spending-heavy package without Republican support, a nationally recognized UC San Diego economist says that government spending pays off as a tool to stimulate the economy. The U.S. Senate is set to start debate on the package Feb. 2.

Researcher Valerie A. Ramey performed an objective analysis on the major issue dividing Democrats and Republicans on how best to get the economy moving again. Her estimates show that a $1 increase in government spending raises GDP by about $1.40.  These estimates are based on historical government spending patterns during defense buildups in the post-World War II U.S. economy. 

Valerie Ramey

On the other hand, Ramey found little stimulus effect from the temporary tax rebate the federal government doled out last spring.  It appears that consumers spent only about 30 per cent of the rebates and used the rest mostly to pay down debts and increase savings. Her analysis of how last year's tax rebate checks were spent convinced Ramey that businesses and taxpayers are not in a mood to be stimulated. The $100 billion in tax reductions bought just $30 billion in demand for goods and services.

"What happened was exactly what economic theory says should happen," says Ramey.  “People knew the tax rebate was temporary, so it didn't make sense for them to go out and splurge. Rebates are not the best way to stimulate spending."

Ramey has recently been consulted by the Congressional Budget Office and economists there are studying here recent paper on this topic.  That research is available at here.

Her findings are bound to cause controversy because both parties in Washington have taken opposite positions on the issue. Republicans have strongly favored tax cuts over spending. President Obama has taken the opposite view. The matter will come to national attention again when the package comes before the U.S. Senate.

But President Obama’s team also is including tax cuts in their stimulus plans. Other economists have said that it is hard for government to come up with smart ways to spend $800 billion. Tax cuts for businesses can be useful in creating the conditions for capital spending and job creation once an economic recovery begins, other experts have said. And a tax cut that ordinary taxpayers perceive as permanent can lead them to increase their consumption once a crisis passes, Ramey said. Also, the stimulus package has a third objective, one that is harder to measure but also crucial: It must ease the fear gripping the economy.

"If people and businesses believe the stimulus will work, they become less afraid and will begin to spend," said Ramey.  "Just that psychic effect could pull the economy out of the doldrums."

In this paper, Ramey focused on the impact of national spending on defense spending over the years. Asked why, she said: “Most nondefense spending is state and local spending on potentially productive activities such as education, so I was looking for an analogy to what is on the table today.”

Ramey has been part of the highly regarded UC San Diego department of economics since 1987.  Her interest in the effects of government spending deepened in the 1990s and she wrote her first major paper on the topic in 1998.

Another one of her major interest is the study of leisure time study, or trends in “time use.”  One conclusion she formed on this topic was that about the same amount of time was being spent for leisure at the end of the 20th century as at the beginning.
           
Ramey, who was awarded her doctorate from Stanford University, teaches public policy and macroeconomics at UCSD.