Order Code RS21136
Updated January 11, 2008
Government Spending or Tax Reduction:
Which Might Add More Stimulus to the
Economy?
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division
Summary
Some policymakers have called for a “stimulus” package to boost economic
activity in response to the housing downturn. A fundamental difference between
stimulus proposals is how much of the stimulus should be composed of government
spending and how much should be composed of 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 would be more stimulative than certain tax
reductions in the short run because 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.
Many economic forecasters predict that the housing downturn and subsequent
financial unrest will reduce economic growth in 2008, perhaps even tipping the economy
into recession.1 Some policymakers have suggested that a stimulus package might be
needed to sustain the economic expansion in light of this economic shock. If so, a key
question in designing a stimulus package is how to get the most short-term “bang for the
buck,” and one important 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
distinguish between the demand-side (aggregate spending) and supply-side (aggregate
production) of the economy. Stimulating the economy refers to boosting aggregate
spending on the demand-side of the economy. Stimulus is employed in a recession
because a recession, by definition, is a situation where aggregate spending is insufficient
to fully employ the economy’s resources.
1 For more information, see CRS Report RL34244, Would a Housing Crash Cause a Recession?,
by Marc Labonte.

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How should the efficacy of a stimulus proposal be evaluated? 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 the long run, and vice
versa. In the short run, many proposals would affect the economy by boosting aggregate
spending; in a slowdown, their effects on the productive capacity (“supply side”) of the
economy are likely to be slight — there is little incentive to add capital or labor when
spending is not adequate to support existing production. In the long run, proposals can
affect economic growth by changing individuals’ work effort, productivity, and the
national saving rate. By contrast, a proposal’s effect on aggregate spending can be
ignored in the long run because aggregate spending can never be permanently altered;
once prices, wages, and credit markets adjust, aggregate spending effects are dissipated.
If judging a proposal whose aim is to stimulate the economy in response to an economic
shock, it seems logical to judge it on the basis of how much it boosts aggregate spending
in the short run. This does not alter the fact that, for better or worse, it will also have
long-run effects.
Evaluating the stimulative nature of different proposals does not answer the question
of whether fiscal stimulus is needed. Expansionary monetary policy by the Federal
Reserve also stimulates the economy.2 In recent months, the Fed has reduced the federal
funds rate on several occasions. In addition, prices, wages, and credit markets naturally
adjust to bring aggregate spending back into line with aggregate production. A look at
the historical record suggests that these two factors have proven highly capable of moving
the economy out of recession in the absence of a fiscal stimulus.3
Short-Run Effects
As a first approximation, any proposal — whether it be a tax or spending proposal
— that increases the size of the budget deficit (or decreases the size of a surplus) would
be expected to boost aggregate spending by some degree, thereby stimulating an economy
operating below its full potential.4 The key is that current proposals would be financed
with borrowed money, and credit markets would not fully adjust immediately in terms of
higher interest rates, so that the spending is “new.” In that context, if the proposal is
offset by spending cuts in other parts of the budget or other tax increases, it will largely
lose its stimulative effect on aggregate demand. Proposals labeled as a “stimulus
package” or, say, “higher military spending” would both stimulate aggregate spending;
the most important determinant of a proposal’s effect is how much the budget deficit
increases as a percentage of gross domestic product (GDP). Because the policy brings
unused resources back into production, the increase in aggregate spending will be greater
than the budgetary cost of the proposal by some “multiplier.” To the extent that interest
rates rise as a result of the decline in saving (increased budget deficit), the multiplier will
2 For more information, see CRS Report RL30354, Monetary Policy and the Federal Reserve,
by Marc Labonte and Gail Makinen.
3 For an evaluation of the relative merits of fiscal and monetary policy, see Economic Growth and
the Business Cycle: Characteristics, Causes, and Policy Implications, by Marc Labonte.
4 For a more detailed analysis, see CRS Report RL31235, The Economics of the Federal Budget
Deficit, by Brian Cashell.

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be reduced because the proposal will tend to “crowd out” private investment and other
interest-sensitive spending. Economic theory suggests it will also crowd out exports and
import-competing goods because higher interest rates will tend to attract foreign capital
that will cause the exchange value of the dollar to appreciate. Similarly, if the proposal
causes inflation to rise, some of the spending will be crowded out as real income falls.
More crowding out will occur as production moves closer to its full potential. This report
does not analyze where the economy is currently operating relative to full potential. If it
is very close, then a stimulus package is unlikely to have the salutary effects its
proponents desire.
All measures that increase the size of the deficit will boost aggregate spending in a
recession to some extent, but some measures are likely to boost it more than others. The
government can increase the budget deficit (or reduce the surplus) in three ways: it can
spend money directly by purchasing goods and services, it can make income transfers by
giving cash or in-kind benefits to selected individuals, or it can cut taxes. (Note that
while in budgetary terms government spending and government transfers are both defined
as outlays, they have different economic meanings and effects.) Government spending
is likely to boost aggregate spending more than tax cuts or a government transfer because
some part of a tax cut or transfer would be saved. By definition, any resources that are
saved cannot add to aggregate spending. Similarly, different tax cuts and transfers will
have different short-run effects because they offer different incentives to save or spend
and their recipients have different spending/saving patterns.
Who should a tax cut or government transfer target to get the most short-run “bang
for the buck?” Empirically, there is evidence that lower income recipients are likely to
spend more of a tax cut or transfer payment than higher income recipients. For example,
two-thirds of families in the bottom 20% of the income distribution did not save at all in
2004, whereas only one-fifth of families in the top 10% of the income distribution did not
save.5 There is no strong theoretical rationale to explain this result. One fairly well-
accepted theoretical explanation holds that lower income recipients are more likely to be
“liquidity-constrained” than higher income recipients, meaning that they are more likely
to lack access to credit markets that allows them to alter their borrowing or saving at will.
Thus, spending a tax cut or transfer payment may allow them to reach a level of
consumption that they would have undertaken if they had unrestrained access to credit
markets.
If the economic effects of both transfer payments and tax cuts depend on the
recipient’s behavioral response, is there any reason to generally expect one or the other
to cause a greater boost in aggregate demand? To answer this question, two further points
are worth considering. First, about 30% of low-income households accrue no federal
income tax liability, although some do pay federal payroll and excise taxes. Thus, there
are limited options for targeting lower income recipients through the individual income
tax. Second, it would be difficult to target an individual tax cut in such a way that it could
only be spent.6 The recipients of tax rebates, income tax cuts, or payroll tax holidays
5 Brian Bucks et al, “Recent Changes in U.S. Family Finances: Evidence from the 2001 and 2004
Survey of Consumer Finances,” Federal Reserve Bulletin, vol. 92, February 2006, pp. A1-A38.
6 It is easier to target a business tax cut in such a way that it must be spent. For instance, a
(continued...)

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would be free to decide whether to save or spend their payment. (A sales tax holiday is
a notable exception, but raises problematic administrative and federalism issues since
sales taxes are levied by state governments.) By contrast, there are other types of tax cuts
such as the expansion of tax deferred savings accounts that are intended to stimulate more
saving, and hence less spending. Certain types of transfer payments, such as food stamps
or rental vouchers, are more easily targeted in such a way that they cannot be saved, and
must be spent. Even these policies do not prevent individuals from shifting an offsetting
amount of any other income into saving, however. Thus, government spending on goods
and services remains the only way to prevent the short-term increase in aggregate
spending from being partially offset by private saving.
In determining a proposal’s short-run efficacy, another issue to consider is the lag
in policy implementation (a separate issue from the lag caused by the legislative process).
It may take a considerable amount of time to set up an administrative infrastructure before
certain government spending or transfer proposals can be implemented. Alternatively,
other proposals expand existing programs and, in some cases, can be implemented quite
quickly. For example, revenue sharing between federal and state governments (sending
fiscal aid to states) could presumably be spent quickly by the states since it would most
likely be used to finance existing state programs whose budgets would otherwise be cut.
Tax cuts typically take effect in the following fiscal year, but exceptions can be made, as
was the case with the 2001 tax “rebate.” The rebate still entailed a lag: P.L.107-16 was
signed into law June 7, 2001, the first rebate checks were issued the week of July 23, and
the last rebate checks were issued the week of September 24.7
Long-Run Effects
Proposals that are good for the economy in the short run, in terms of boosting
aggregate spending, are often bad for the economy in the long run due to the spending-
saving dichotomy. Long-run growth depends on investment, work effort, and productivity
gains. Investment, in turn, depends on saving. Since a budget deficit lowers national
saving (while a surplus increases national saving), virtually any policy that increases the
budget deficit would lower national saving. Thus, measures that boost aggregate
spending in the short run will lower saving, and therefore growth, in the long run. The
extent that national saving is reduced, in turn, depends on how much private saving
offsets the reduction in public saving (the increase in the deficit).
The fact that some part of a tax cut is likely to be saved gives tax cuts an advantage
over most government spending in the long run. In turn, a tax cut can be crafted to
generate more saving by targeting higher income individuals (who have higher saving
rates) or targeting saving directly (e.g., expanding tax-deferred saving accounts). Whether
tax cuts actually induce private saving depends on whether individuals react to the higher
after-tax rate of return by saving more because it is more rewarding (the substitution
6 (...continued)
business could claim the proposed accelerated depreciation only if it purchased new capital. See
CRS Report RL31134, Using Business Tax Cuts to Stimulate the Economy, by Jane Gravelle.
7 For more information, see CRS Report RS21171, The Rate Reduction Tax Credit in the
Economic Growth and Tax Relief Reconciliation Act of 2001: A Brief Explanation, by Gregg
Esenwein and Steven Maguire.

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effect) or by saving less because less saving is now needed to reach their goal (the income
effect). Similarly, tax cuts can be crafted to increase the rewards for working. Whether
this generates more work effort depends on whether people work more in response to
higher after-tax pay (substitution effect), or work less because less work is now needed
to achieve a given standard of living (income effect). If a tax cut generates more work
effort, this could also help offset the negative effects on economic growth of raising the
deficit. Only marginal tax cuts have substitution effects that could potentially induce
more work or saving; if tax expenditures (deductions, credits, or exclusions) were cut
instead, there would be an unambiguously negative effect on work and saving in most
cases because there would be an income effect but no substitution effect.
Most government spending and transfers do not increase the incentives for
individuals to work or save. The negative effects on long-run growth caused by the larger
budget deficit, therefore, would not be offset. There are exceptions, such as government
spending on public investment. Instead of diverting resources from private investment
to public consumption, as most government spending does, it diverts resources from
private investment to public investment. Productivity in government may grow more
slowly than it does in the private sector over time, also causing government spending to
detract from long-run growth.
Although transfer payments may have significant social value, they can also reduce
the incentives to work and save if they are means-tested for income level. A reduction
in transfer payments when income rises is equivalent to the incentive effects of a marginal
income tax, and some individuals may reduce their work effort or saving to avoid this de
facto marginal tax. Likewise, unemployment benefits can lower the incentive to find
work. On the other hand, there are examples of transfer payments that increase the
incentive to work, such as transfer payments for which only employed individuals are
eligible.

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