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1 Marc Labonte, Government Spending or Tax Reduction: Which Might Add More Stimulus to the Economy 1 (January 28, 2003)

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                                                                Order Code RS21136
                                                           Updated January 28, 2003



 CRS Report for Congress

              Received through the CRS Web




    Government Spending or Tax Reduction:
      Which Might Add More Stimulus to the

                            Economy?

                              Marc Labonte
                                Economist
                    Government and Finance Division

Summary


     Members have proposed several stimulus measures to help end the recession.
 A fundamental difference in competing stimulus packages is how much of the stimulus
 should be devoted to government spending and how much should be devoted to tax cuts.
 This report considers that issue in the context of conventional economic analysis. It first
 identifies any policy change that increases the budget deficit (or reduces a surplus) and
 is not entirely saved by the recipient as stimulative if the economy is operating below
 its full potential. It then separates the short-run effects of a budget deficit from the long-
 run effects. In this context, certain spending proposals may be more stimulative than
 certain tax reductions in the short run if they result in a bigger boost in aggregate
 spending. This advantage may come at the cost of forgone growth in the long run,
 however. This report will be updated as events warrant.

    In March 2001, the U.S. economy entered a recession, and Members of Congress
have since proposed several stimulus packages in response. On March 9, 2002 a
stimulus package was signed into law (P.L.107-147) that included an acceleration in
depreciation rates and an extension of unemployment benefits. In January 2003, the
President introduced a proposal for economic growth and job creation that focused on
tax cuts. Throughout this year's and last year's debate, there has been heated debate
concerning how to get the most short-term bang for the buck out of any stimulus
package, and one key element of that debate is whether spending proposals or tax
reductions would be more effective in that regard. To answer that question, one must first
understand why the economy has entered a recession. While the ultimate causes are
complex and diverse, they can be boiled down to one proximate cause: spending
(aggregate demand) in the economy is currently lower than what could be produced if the
economy were at full employment (aggregate supply).

    Given the cause of the recession, how should a stimulus proposal be judged? By
whether it boosts economic growth might seem to be an obvious answer, but the answer
is a little more complicated. Policy proposals have distinct short-run and long-run
economic effects, and often a proposal beneficial in the short run may be detrimental in

       Congressional Research Service **o The Library of Congress

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