Effectiveness of Fiscal Policy as a Stabilization Tool
The Effectiveness of Fiscal Policy as Stabilization Policy
Alan J. Auerbach University of California, Berkeley July 2005
This paper was presented at the Bank of Korea International Conference, The Effectiveness of Stabilization Policies, Seoul, May 2005. I am grateful to my discussants, Takatoshi Ito and Chung Mo Koo, and other conference participants for comments on an earlier draft.
I. Introduction
Perspectives among economists on the usefulness of fiscal policy as a device for macroeconomic management have moved back and forth over the years. Belief in the active use of the tools of fiscal policy may have reached a relative peak sometime during the 1960s or early 1970s, and practice followed theory. In the United States, perhaps the best illustration of the evolution of theory and practice comes from the investment tax credit (ITC), which, when it was in effect, provided businesses with a strong incentive for equipment investment. The ITC, first introduced during the Kennedy administration in 1962, at a rate of 7 percent, was adjusted frequently in response to changes in economic conditions. It was strengthened in 1964, the same year in which major income tax reductions were introduced, suspended in 1966 during a boom associated with the Vietnam War, reinstated in 1967, “permanently” repealed in 1969 during a period of inflationary pressure, reinstated again in 1971, just after the trough of the first recession since early 1961, and increased to a rate of 10 percent in 1974, toward the end of the next recession. Although not necessarily conceived originally as a tool for stabilization policy, the ITC clearly became one during this period. Yet, skepticism about the usefulness of such activism soon appeared. In an early evaluation of the effectiveness of the credit, Gordon and Jorgenson (1976) concluded that the actual variations in the ITC just described had destabilized the economy. They argued that some of the policy changes were timed poorly, and that
Alan J. Auerbach University of California, Berkeley July 2005
This paper was presented at the Bank of Korea International Conference, The Effectiveness of Stabilization Policies, Seoul, May 2005. I am grateful to my discussants, Takatoshi Ito and Chung Mo Koo, and other conference participants for comments on an earlier draft.
I. Introduction
Perspectives among economists on the usefulness of fiscal policy as a device for macroeconomic management have moved back and forth over the years. Belief in the active use of the tools of fiscal policy may have reached a relative peak sometime during the 1960s or early 1970s, and practice followed theory. In the United States, perhaps the best illustration of the evolution of theory and practice comes from the investment tax credit (ITC), which, when it was in effect, provided businesses with a strong incentive for equipment investment. The ITC, first introduced during the Kennedy administration in 1962, at a rate of 7 percent, was adjusted frequently in response to changes in economic conditions. It was strengthened in 1964, the same year in which major income tax reductions were introduced, suspended in 1966 during a boom associated with the Vietnam War, reinstated in 1967, “permanently” repealed in 1969 during a period of inflationary pressure, reinstated again in 1971, just after the trough of the first recession since early 1961, and increased to a rate of 10 percent in 1974, toward the end of the next recession. Although not necessarily conceived originally as a tool for stabilization policy, the ITC clearly became one during this period. Yet, skepticism about the usefulness of such activism soon appeared. In an early evaluation of the effectiveness of the credit, Gordon and Jorgenson (1976) concluded that the actual variations in the ITC just described had destabilized the economy. They argued that some of the policy changes were timed poorly, and that
References: Source: Fátas and Mihov (2003), Figure I 2