AAssessingssessing thethe MacroMacro EEconomicconomic ImpactImpact ofof FFiscaliscal StimulusStimulus 20082008

bbyy MMarkark M.M. ZandiZandi

121 N. Walnut Street • Suite 500 • West Chester, PA 19380 • USA [email protected] • 866.275.3266 (inside the USA) • 610.235.5000 (outside the USA) Assessing the Macro Economic Impact of Fiscal Stimulus 2008

he president and Congress are the risks of and the need for Arizona, California, Florida, Michigan quickly coalescing around a fiscal stimulus. The economy is indeed and Nevada. These states account for a T fiscal stimulus plan to shore struggling. Real GDP likely grew near 1% fourth of national GDP. Alaska, Arkansas, up the flagging economy. As currently in the fourth quarter of 2007, and the Connecticut, Minnesota, Missouri, Ohio, envisioned, the plan is expected to cost economy appears to be contracting in Rhode Island, Vermont and Virginia at least $150 billion and include a sizable early 2008. The job market has stalled, are on the edge of recession. These tax rebate, short-term tax incentives for Christmas sales were soft, and industrial states account for an additional 15% business , and temporary production has gone flat. of national GDP. The large metro area increases in unemployment insurance The threat of recession is evident economies of the Northeast from Boston benefits and food stamps. This stimulus in the recent substantial increase in to Washington, D.C. are still expanding, will not prevent a recession if one is unemployment. The jobless rate has but growth is slowing sharply, particularly already on its way, as its benefits will not risen 0.6 percentage points from its around New York City, which is being be realized until summer; however, it 4.4% cyclical low last March to 5% hurt by Wall Street’s travails. If these could substantially mitigate the severity in December. are always economies begin to contract, a national of any downturn. Under reasonable preceded by such a rise, and one has recession will have begun (see Chart 2). assumptions, the stimulus will add 1½ never occurred without a recession The need for fiscal stimulus is percentage points to annualized real ensuing (see Chart 1). Unemployment is reinforced by the possibility that GDP growth during the second half of typically the catalyst for a recession spiral has become less 2008. will grow by an extra because increased joblessness undermines 700,000 jobs, and the unemployment rate consumer confidence and thus consumer will be as much as a half percentage point spending. Businesses respond to flagging  Regional economies are determined by Moody’s Economy. lower by mid-2009 than would be the sales by cutting back investment and com to be in recession using a methodology similar to that case without Washington's help. payrolls, and unemployment rises further. developed by the National Bureau of Economic Research for gauging national recessions. Payroll employment and Why stimulus? With a presidential A negative, self-reinforcing cycle begins. industrial production are the two principal indicators of election fast approaching, policymakers A number of large state economies persistent, broad-based decline in economic activity. A list of have come to a quick consensus regarding are likely already in recession, including metro areas in or near recession is available on request.

Chart 1: Rising Unemployment Signal Recession Chart 2: State Economies in or Near Recession Year-over-year % change in unemployment 80 Source: BLS 70 60 50 40 30 20 10 0 -10 -20 In recession Near recession -30 Expansion 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07

Moody’s Economy.com • www.economy.com • [email protected] • January 2008  Chart 3: The Mortgage Securities Market Shuts Down Chart 4: The Must Turn More Aggresive Bond issuance, $ bil, annualized Federal funds future contract for Sepetember 2008

1,000 4.50 Jumbo Alt-A 4.25 Subprime 800 4.00

3.75 600 3.50

400 3.25

3.00 200 2.75 Source: CBOT 2.50 0 01 02 03 04 05 06 07H1 07H2 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 effective in stimulating growth. The most and implemented through the political season—a time when refiners’ operating immediate conduit between monetary process, making it difficult to put together margins rise with consumer demand. If policy and the economy runs through a plan quickly enough to support a refiners’ margins return to their long- the housing market. Housing is the struggling economy. Historically, the run historical norms, a gallon of regular most interest rate-sensitive sector of the action often took effect well after the unleaded gasoline will sell for $4, up from economy, and historically it would receive economy had recovered, making such just over $3 currently. Since every 1-cent a quick boost from monetary easing. stimulus counterproductive. per gallon increase in gasoline prices costs This boost will be much more muted This criticism should be at least consumers more than $1 billion annually, today given the ongoing problems in the partially stilled by the relatively rapid Americans’ driving bills are set to increase by mortgage securities market. Issuance of response of policymakers during and after $100 billion. That acts very much like a tax bonds backed by subprime, alternative-A, the 2001 recession. Washington enacted increase; if households must spend more to and jumbo mortgage loans has collapsed a tax rebate, extended unemployment drive, they have less to spend on everything (see Chart 3). Save for conforming fixed- insurance benefits beyond the usual 26 else. The impact is even more pernicious rate loans, which are only loosely tied weeks, accelerated depreciation for new than a tax increase, since tax proceeds to Fed actions, lenders are unable and business investment, and imposed other typically finance government spending, unwilling to extend mortgage credit at any smaller tax cuts and benefits. The cost whereas much of what is spent on gasoline interest rate. was approximately $100 billion, equal goes to overseas energy producers. The Federal Reserve may also to about 1% of GDP. While subject to The $150 billion stimulus plan can be constrained in its response to the much debate then and afterward, this also be thought of as making up for the economy’s problems because of concerns stimulus likely mitigated the severity of difference between current consensus with , which remains elevated that downturn. expectations this year and the economy’s despite the weak economy. Commodity How big a plan? President Bush’s potential growth. While economists have prices are at record levels, the exchange currently proposed fiscal stimulus plan quickly marked down their forecasts, value of the U.S. dollar is falling, import is a comparable 1% of GDP, equal to just according to the Blue Chip survey the prices are up and labor productivity under $150 billion. This is big enough consensus is for real GDP to advance has slowed. Financial markets have to to provide a meaningful economic boost. less than 2% this year. Most economists date been disappointed with the Federal Assuming the $150 billion is distributed have not assumed the passage of a fiscal Reserve’s reticent response to events. this summer, and that just half is actually stimulus plan, and most put potential Investors may be even more disappointed spent by year’s end, it would add well over growth at below 3%. If economists are in coming weeks as they are pricing in a a percentage point to annualized real GDP correct about growth this year, then a near 2% federal funds rate target by late growth during the second half of 2008. $150 billion stimulus plan would simply this year, down from 3.5% currently (see How big a boost, of course, depends on put the economy back closer to its trend. Chart 4). Well-timed and temporary fiscal the details of the stimulus plan. If economists are wrong, it is likely they stimulus could jump-start growth and Another way to gauge the magnitude will have erred on the side of optimism, give monetary authorities more latitude to and importance of the $150 billion and the economy is already in recession. focus on longer-term inflation objectives. stimulus package is to consider the In that case fiscal stimulus would be The use of to support looming potential increase in the cost of especially helpful. a flagging economy has also regained gasoline this spring. If oil prices remain Tax rebate. The goal of a fiscal credibility given its successful deployment near their current $90 per barrel, gasoline stimulus plan is to maximize the near- in 2001. A valid criticism of fiscal prices will increase sharply once refiners term boost to without stimulus is that it must be fashioned begin gearing up for this summer’s driving weakening the economy’s longer-term

 Moody’s Economy.com • www.economy.com • [email protected] • January 2008 households spending two-thirds of their Table 1: Fiscal Economic Bang for the Buck rebate within six months of receiving a One year $ change in real GDP for a given $ reduction in federal tax revenue or increase  in spending check. Moody’s Economy.com’s estimate of a tax rebate’s potential stimulus is Tax Cuts closer to these later estimates. A majority Non-refundable lump-sum tax rebate 1.02 of households save little, and have modest if any net worth. They likely have very Refundable lump-sum tax rebate 1.26 short-term financial-planning horizons— indeed, not much further than their next Temporary tax cuts paycheck. Any tax benefit they receive will payroll tax holiday 1.29 almost certainly be spent quickly. Across the board tax cut 1.03 The president has seemingly decided Accelerated depreciation 0.27 to separate the debate over a fiscal stimulus plan from the issue of whether Permanent tax cuts to make the tax cuts passed early in his Extend alternative minimum tax patch 0.48 presidency permanent. Under current Make Bush income tax cuts permanent 0.29 law, those tax cuts are set to expire at Make dividend and capital gains tax cuts permanent 0.37 the end of the decade. Indeed, making Cut in corporate tax rate 0.30 them permanent would provide very little economic stimulus at this point. Spending Increases Some households would spend more Extending UI benefits 1.64 freely given the certainty of their lower Temporary increase in food stamps 1.73 future tax rates, but most do not have the financial resources to do so. The benefit General aid to state governments 1.36 of making Bush’s tax cuts permanent Increased infrastructure spending 1.59 would also be mitigated by their impact Source: Moody's Economy.com on long-term interest rates. Bond investors holding with prospects. This requires that the thus get either no refund or only a partial maturities that extend for decades are plan be implemented quickly; that its one. Taxpayers would likely receive highly sensitive to policy changes that will benefits go to those hurt most by the checks beginning in mid-June, as the IRS have long-run implications for the federal economy’s problems; and that these processes 2007 tax returns. The checks fiscal situation. benefits not damage longer-term fiscal would be mailed over a period extending While the president’s non-refundable conditions. Yet given the number of into August. tax rebate would help the struggling political constituencies involved, these The president’s favored tax rebate economy, a refundable rebate would requirements may not serve as more plan would provide a measurable be substantially more helpful. In a than a rough guide for the stimulus plan quick boost to the economy. Based on refundable tax rebate—favored by most currently being fashioned. simulations of the Moody’s Economy.com Democrats—all households would The most significant part of the macroeconomic model, every dollar lost to receive the same size check regardless proposed plan will be a tax rebate. The the Treasury from the rebate would generate of how much they owe in income taxes. president favors a “non-refundable” rebate slightly more than one dollar in GDP within For example, at a cost of $100 billion, that would be based on the elimination of one year (see Table 1). Given that the every U.S. household could receive a the 10% income tax bracket for this year. president’s rebate would cost around $100 $900 check. The extra boost would come The maximum rebate would be $800 for billion, it would add a bit more than $100 via the spending of very low income an individual filer and $1,600 for joint billion to GDP by mid-2009. households, who will not receive a non- filers. Those who do not earn enough There is significant debate about the refundable rebate since they typically do to pay income tax would get no rebate economic efficacy of temporary tax cuts. not owe income taxes. Moreover, higher (hence the “non-refundable” designation), Survey-based studies of the 2001 tax income households who are more likely and many with lower incomes that pay rebate concluded that only about a fourth to save their rebate check receive less some taxes will get only a partial rebate. of the rebate was spent; the rest was under a refundable plan. Over half of all U.S. households would saved or used to pay down existing debt. Investment incentives. The fiscal More recent data-based studies found stimulus plan will likely also include the 2001 rebate to be more potent, with tax incentives to stimulate business  A good review of the various potential tax and spending investment. This is not a particularly elements of a fiscal stimulus plan are provided in “Options effective way to boost near-term economic for Responding to Short-Term Economic Weakness,” Congressional Budget Office, January 2008.  The tax rebate could be issued earlier if it were based on  The need for fiscal stimulus to be timely, targeted and 2006 tax returns, but this would clearly create another set temporary is very nicely described in “If, When, How: A of issues. Primer on Fiscal Stimulus,” Douglas Elmendorf and Jason  See “Consumer Response to Tax Rebates,” Matthew  See “Household Expenditure and the Income Tax Rebates Furman, The Hamilton Project, Brookings Institution, Shapiro and Joel Slemrod, American Economic Review, of 2001,” Johnson, Parker, and Souleles, American Economic January 2008. Volume 93, No. 1, March 2003, pp. 281-396. Review, Volume 95, No. 6, December 2006, pp 1589-1610.

Moody’s Economy.com • www.economy.com • [email protected] • January 2008  Chart 5: Mounting State Government Fiscal Problems Expanding Increasing food stamp benefits also Red states have announced budget shortfalls for FY 2009 UI and food has the added benefit of helping many stamps. While low-income households ineligible for UI, there will be such as part-time workers. It also helps some resistance those who do not pay income tax and from the Bush thus will not receive a rebate. administration, it is Helping state governments. Another likely the stimulus economically potent tool of the federal plan will include government is aid to financially-pressed some temporary state governments. This could take the increases in form of general aid or a temporary increase federal spending. in the Medicaid matching rate, to help ease An extension the costs of health coverage. Such help of benefits for appears unlikely in the current stimulus unemployed plan, but this could quickly change in workers who coming weeks if the economy’s problems exhaust their grow more severe and widespread as the regular 26 weeks legislation is being fashioned. activity, but it will make any plan more of unemployment insurance benefits Fiscal problems are already politically palatable and thus smooth its has been part of the federal government developing in nearly half the states. quick passage. response to most past recessions, and an Fourteen states have announced specific Included in the 2001-2002 stimulus expansion of food stamp payments also budget shortfalls in fiscal year 2009, was bonus depreciation for new seems likely. Including these spending which begins this July, totaling close investment and increased expensing of increases would assure more support to $30 billion. Tax revenue growth has investment for small businesses. Under among Democrats for a stimulus plan and slowed sharply with flagging retail sales bonus depreciation a business is able to thus facilitate its passage. and corporate profits. Income tax receipts more quickly depreciate new investment Extending UI and expanding food are also sure to suffer as the job market undertaken before a certain date. This stamps are the most effective ways weakens. California and Florida are under lowers the firm’s tax liability, raises the to prime the economy’s pump. A $1 the most financial pressure, but states after-tax return on that investment, and increase in UI benefits generates an as far-flung as Arizona, Minnesota, and should thus induce businesses to invest estimated $1.64 in near-term GDP; Maryland are also struggling. more quickly. Similar dynamics apply to increasing food stamp payments by $1 As most state governments are small-business expensing. The economic boosts GDP by $1.73 (see table). People required by their constitutions to quickly efficacy of these incentives grows if there who receive these benefits are very hard- eliminate their deficits, most are already is a near-term expiration date. In the pressed and will spend any financial aid drawing up plans to cut funding for current stimulus plan, the investment they receive within a few weeks. These programs ranging from healthcare to incentives will likely include bonus programs are also already operating, and education and cutting grants to local depreciation of 50% and a doubling in a benefit increase can be quickly delivered government. Local governments are expensing to $250,000 on to recipients. having their own financial problems; made before the end of 2008. The benefit of extending most rely on property-tax revenues, which The economic bang-for-the-buck of unemployment insurance goes beyond are slumping with house prices. Cuts in bonus depreciation is very modest (see simply providing financial aid for the state and local government outlays are table). Indeed, of all the tax and spending jobless, to more broadly shoring up sure to become a substantial drag on the policies considered, it provides the least household confidence. Nothing is more economy later this year and into 2009. amount of stimulus. Such incentives offer a psychologically debilitating, even to Additional federal aid to state limited boost because many businesses have those still employed, than watching governments will fund existing payrolls difficulty quickly adjusting long-planned unemployed friends and relatives and programs; thus it will also provide a capital budgets. Moreover, most investment lose benefits. The slump in consumer relatively quick economic boost. States that is made by businesses with no tax liability confidence in late 1991, after the receive a check from the federal government in the first place. Investment incentives also 1990-1991 recession, may very well will quickly pass on the money to workers, complicate matters for financially pressed have been due in part to the first Bush vendors, and program beneficiaries. state governments that base their business administration’s initial opposition to Arguments that state governments taxes on federal tax law. extending UI benefits for hundreds of should be forced to cut spending that thousands of workers. The administration has grown bloated and irresponsible, ultimately acceded and benefits were are strained at best. State government  The economic efficacy of investment tax incentives extended, but only after confidence had spending and employment are no larger provided earlier this decade is examined in “A Retrospective Evaluation of the Effects of Temporary Partial Expensing,” waned. The fledgling recovery sputtered today as a share of total economic activity Cohen and Cummings, Federal Reserve Board, Finance and and the political damage extended and employment than they were three Discussion Series Working Paper No. 2006-19, April 2006. through the 1992 presidential election. decades ago. Moreover, arguments that

 Moody’s Economy.com • www.economy.com • [email protected] • January 2008 Chart 6: Quick Fiscal Stimulus Would Support GDP... Chart 7: ...Lift Employment... Contribution to real GDP growth, average annual % change Change in payroll employment, thousands 2.25 1,100 1,023 Likely stimulus Likely stimulus 2.00 2.13 1,000 Optimal stimulus Optimal stimulus 900 1.75 1.54 800 1.50 705 700 646 1.25 600 1.00 500 448 400 0.75 0.65 0.53 300 0.50 200 0.25 100 0.00 0 2nd half of 08 First half of 09 Dec-08 Jun-09 helping states today would encourage to know just when the projects will get to the economy during the second half of more profligacy in the future also appear under way and the money spent. Also this year and early in 2009. Neither plan overdone. Apportioning federal aid to complicating the use of infrastructure will prevent a recession if one has already states based on their size (either by spending is the politics of apportioning begun, because they will not benefit the GDP or population), rather than on the these funds across the country in economy until midyear at best. Yet they are size of their budget shortfalls, would a logical and efficient way. Simply substantive enough to significantly mitigate substantially mitigate this concern. allocating the funds proportionately the severity and length of any downturn. Other options. Fiscal policymakers could very well result in some poorly Taking the president’s lead, have a number of other options for designed projects being funded. Congress is most likely to pass a fiscal providing stimulus, some of which have Making the current dividend income stimulus plan costing $150 billion. The been used in the past, but have some and capital gains tax rates permanent plan will include a non-refundable $100 significant shortcomings and are thus not would also make for poor economic billion tax rebate; bonus depreciation likely to be included as part of the current stimulus. The current 15% tax rate and increased expensing for small stimulus plan. Most notable are spending that most investors currently pay is set businesses costing $25 billion; and on the nation’s infrastructure and making to soon expire and tax rates will jump. an extension of UI benefits and an the current tax rates on dividend income There is an argument that making them expansion of food stamps that together and capital gains permanent. permanent would create some certainty account for the remaining $25 billion. On the face of it, increased for investors who are currently very We assume the plan becomes law in infrastructure spending appears to be a uncertain regarding the prospects for the March, and the tax rebate is issued particularly efficacious way to stimulate stock and bond markets. Regardless of between mid-June and mid-August. The the economy. The boost to GDP from a the longer-term benefits of taking such investment incentives and the expanded dollar spent on building new bridges and a policy step, however, the near-term UI and food stamp benefits are assumed schools is estimated to be a large $1.59, economic boost would be small. The to extend through mid-2009. and who could argue with the need problems plaguing financial markets This plan will lift annualized real for such infrastructure. The overriding are broad and deep and unlikely to be GDP growth by 1.5 percentage points limitation of such spending as a part measurably affected by such a policy during the second half of 2008, and of a stimulus plan, however, is that it change. Moreover, even under the best by 0.5 percentage points during the generally takes a substantial amount of circumstances in financial markets, first half of 2009. (see Chart 6). The of time for funds to flow to builders the impact of such a move has a small additional output growth translates into and contractors and into the broader estimated economic bang-for-the-buck of nearly 450,000 more jobs by year-end economy (see Table 1). It should be only $.37. 2008 than would be created without noted that the economic bang for the buck Macroeconomic impacts. To assess the stimulus, and 700,000 more estimates shown in Table 1 measure the the macroeconomic consequences of jobs by midyear 2009 (see Chart 7). change in GDP one year after the spending fiscal stimulus, Moody’s Economy.com Unemployment will be measurably lower actually occurs; it says nothing about how simulated two different hypothetical as a result, with the jobless rate nearly long it may take to cut a check to a builder plans. The first plan is the most likely half a percentage point lower by mid- for a new school. Many infrastructure to become law given current political 2009 (see Chart 8). projects can take years from planning to realities, while the second is an idealized completion. Even if the funds are only plan whose objective is maximizing near- used to finance projects that are well term economic growth, without regard to  Monetary policy as measured by the federal funds rate is along in their planning, it is very difficult politics. Both provide a measurable boost determined endogenously in the model based on a Taylor- rule reaction function.

Moody’s Economy.com • www.economy.com • [email protected] • January 2008  Chart 8: ...And Lower Unemployment than would be current period, the real funds rate has Change in unemployment rate, basis points case without the fallen from 3% to 1.25% and there has Dec-08 Jun-09 stimulus, and been no fiscal policy response. 0.00 0.7 percentage Policymakers must act now to points greater in shore up the unraveling economy. The the first half of Federal Reserve has become much more next year. Payroll aggressive, slashing the federal funds rate -0.25 employment by 1.75% since the summer to a current -0.29 is more than 1 target of 3.5%. Even more rate-cutting is million jobs higher likely on the way. Various fiscal automatic -0.42 by mid-2009 as stabilizers are now beginning to kick in as -0.50 -0.46 a result, and the the economy falters. Tax revenue growth

Likely stimulus unemployment is sure to soon slow sharply, and spending Optimal stimulus rate is 0.7 on various transfer programs will quickly -0.66 percentage ramp up. Even if the Bush administration -0.75 points lower. and Congress do nothing in response to The idealized the eroding economy, the budget deficit stimulus plan will increase substantially. Under our idealized stimulus plan, leads to 300,000 more jobs by mid- Doing nothing would be a mistake, which we also assume to cost $150 2009 than in the most likely plan, and however. Fiscal policymakers have billion, there is a refundable tax rebate an unemployment rate that is a quarter a window of opportunity to provide worth $100 billion; $25 billion for percentage point lower. substantial help in a timely and targeted increased spending on UI benefits and Conclusions. The U.S. economy way. A well-designed tax rebate this food stamps; and $25 billion in state may not be able avoid a recession summer, plus additional help to government aid. The tax rebate is issued in coming months; but with deft financially-pressed households reliant this summer, and the extra spending is and aggressive monetary and fiscal on unemployment insurance and food assumed to take place through mid-2009. policymaking, we can ensure that if the stamps would go far in boosting a The key differences between the optimal economy suffers a downturn it will be flagging economy. The stimulus should and most likely stimulus plans are the short and modest. be temporary, so that the resulting refundable versus non-refundable tax Indeed, the last two recessions in larger deficit this year and next does not rebate and state government aid instead 2001 and 1990-1991 were short and exacerbate the nation’s long-term fiscal of business investment incentives. The mild by post-World War II standards, but challenges. A well-timed, targeted, and refundable tax rebate is assumed to be only because of the aggressive monetary temporary stimulus could in fact cost based on payroll tax rolls that are much and fiscal stimulus provided to shore the Treasury less in the long run, since broader than federal income tax rolls; the up the economy. In the early 1990s’ a debilitating recession would severely state government aid is provided to states’ downturn, the real federal funds rate fell undermine tax revenues and prompt more via grants to their general funds. from 5% to 0%, and the federal budget government spending for longer. The boost to GDP growth from deficit increased from 3% to 5% of GDP. What policymakers decide to do the idealized fiscal stimulus plan is Early in this decade, the real funds rate or not do in the next few weeks will substantial. Annualized real GDP growth fell from 4% to -1%, and the federal determine whether millions of Americans is estimated to be 2.1 percentage points budget went from a surplus equal to 2% lose jobs this year, and will significantly greater during the second half of 2008 of GDP to a deficit of 4%. So far in the affect the economic well-being of all of us.

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