By Ron Robins. First published April 7, 2011, in his weekly economics and finance column at alrroya.com

What should overly indebted developed country governments do to spur economic activity and reduce deficits and debt? Should they spend more, or less? Should taxes be increased, or lowered? A number of recent studies collectively suggest that government stimulus spending provides no stimulus at all beyond the amount spent. But where there are large deficits, spending should be cut. However, the best way to stimulate the economy is through lower taxes—and especially to cut corporate taxes! But what a political bombshell these policies would be in many countries.

Increased government spending, say numerous economists trained in traditional Keynesian economic theory, should have a ‘multiplier’ effect that increases overall economic activity by an amount larger than the sum spent. However, some recent empirical research disputes that assumption.

In a prestigious US National Bureau of Economic Research (NBER) study, Identifying Government Spending Shocks: It’s All in the Timing, by Valerie A. Ramey, published in October 2009, she found that, “… none of my results indicate that government spending has multiplier effects beyond its direct effect.” That is a dollar of government spending contributes only about a dollar to economic activity.

Furthermore, the same conclusion was noted by Harvard University’s Economics Professor Greg Mankiw while reviewing new research in his blog post, “Spending and Tax Multipliers” on December 11, 2008. He stated “…Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar.”

So, these studies indicate that increasing government spending does not increase economic activity by anything more than the original sum spent.

By contrast, cutting taxes may have a much larger economic multiplier effect. Quoting Professor Mankiw again, he says, “…research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars…” (Incidentally, Christina Romer was chairman of President Obama’s Council of Economic Advisers in 2009-2010.)

Furthermore, Professor Mankiw adds that, “…these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favourite textbook, spending multipliers necessarily exceed tax multipliers… How can these empirical results be reconciled? One hypothesis is that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favourable to capital investment–a mechanism absent in the textbook Keynesian model.”

Reviewing the spend and tax empirical data for most developed countries suffering from large deficits and debt is this study, Large Changes in Fiscal Policy: Taxes Versus Spending, by Alberto F. Alesina and Silvia Ardagna—another NBER paper, dated October 2009. They state, “we examine the evidence… of fiscal stimuli [stimulus] and in… fiscal adjustments [reducing deficits] in OECD countries from 1970 to 2007. Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.”

So if cutting taxes gives the best boost to economic activity, are there particular taxes to cut that provide the most economic stimulus? The answer is yes, according to the OECD study, Tax Policy Reform and Economic Growth, November 3, 2010. The reviewers say that, “…corporate taxes are the most harmful type of tax for economic growth, followed by personal income taxes and then consumption taxes, with recurrent taxes on immovable property being the least harmful tax.”

Corroborating these findings is another recent peer reviewed study supporting lower corporate taxes: The Effect of Corporate Taxes on Investment and Entrepreneurship, published in the American Economic Journal in July 2010. It stated, “in a cross-section of countries, our estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI [foreign direct investment], and entrepreneurial activity… The results are robust to the inclusion of many controls.” (The authors were from the World Bank: Simeon Djankov, Caralee McLiesh and Rita Ramalho. And from Harvard University: Tim Ganser and Andrei Shleifer.)

Based on this evidence, some observers argue to significantly reduce or even eliminate corporate taxes entirely! In fact, many countries and jurisdictions are reducing corporate taxes significantly, exactly because of such studies. Though no country has yet eliminated them altogether.

Most of these respected studies variously infer that one optimal solution to spur economic growth in developed countries is to cut taxes, while to reduce onerous government deficits and debt, Alberto F. Alesina and Silvia Ardagna suggest cutting spending. Moreover, some of these studies clearly demonstrate that to promote economic growth, governments should most especially cut corporate taxes. Of course this is advocated by some US ‘Tea Party’ leaders, though it is a problematic issue for electorates in many developed countries.

However, shouldn’t at least one country try eliminating corporate taxes entirely? Now that would be one country to study!

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