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Budget Deficits, Tax Incentives and Inflation: A Surprising Lesson From The 1983-84 Recovery

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  • Martin Feldstein
  • Douglas W. Elmendorf

Abstract

The first two years of the economic expansion that began in 1983 were unusually strong and were accompanied by better inflation performance than would have been expected on the basis of experience in past recoveries. Our evidence contradicts the popular view that the recovery was the result of a consumer boom financed by reductions in the personal income tax. We also find no support for the proposition that the recovery reflected an increase in the supply of labor induced by the reduction in personal marginal tax rates. The driving force behind the recovery of nominal demand was the shift to an expansionary monetary policy. The rapid expansion of nominal GNP can be explained by monetary policy without any reference to changes in fiscal and tax policy. But the growth of real GNP was more rapid than would have been expected on the basis of the rise in total nominal spending and the increase in the price level was correspondingly less. The most likely cause of this favorable division of the nominal GNP increase was the sharp rise in the dollar that occurred at this time. Although part of the dollar's rise can be attributed to the successful anti-inflationary monetary policy, the dollar also increased because of the rise in real interest rates that resulted from the combination of the increase in anticipated budget deficits and the improved tax incentives for investment in equipment and structures. Thus, expansionary fiscal policy did contribute to the greater-than-expected rise of real GNP in 1983-84 but it did so through an unusual channel. The fiscal expansion raised output because it caused a favorable supply shock to prices and not because it was a traditional stimulus to demand. The budget deficit and investment incentives were expansionary in the short run because, by causing a rise of the dollar, they reduced inflation and thus permitted a faster growth of real GNP.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2819.

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Date of creation: Jan 1989
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Publication status: published as Tax Policy and the Economy, vol. 3, 1989. (ed) L. Summers, pp1-24, MIT Press
Handle: RePEc:nbr:nberwo:2819

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  1. Martin Feldstein & Joosung Jun, 1986. "The Effects of Tax Rules on Nonresidential Fixed Investment: Some Preliminary Evidence from the 1980s," NBER Working Papers, National Bureau of Economic Research, Inc 1857, National Bureau of Economic Research, Inc.
  2. William Poole, 1987. "Monetary Policy Lessons of recent Inflation and Disinflation," NBER Working Papers, National Bureau of Economic Research, Inc 2300, National Bureau of Economic Research, Inc.
  3. Jeffrey D. Sachs, 1985. "The Dollar and the Policy Mix: 1985," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 117-197.
  4. Martin Feldstein, 1986. "Supply Side Economics: Old Truths and New Claims," NBER Working Papers, National Bureau of Economic Research, Inc 1792, National Bureau of Economic Research, Inc.
  5. Leonall C. Andersen & Jerry L. Jordon, 1968. "Monetary and fiscal actions: a test of their relative importance in economic stabilization," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue Nov, pages 11-23.
  6. Martin Feldstein, 1986. "The Budget Deficit and the Dollar," NBER Working Papers, National Bureau of Economic Research, Inc 1898, National Bureau of Economic Research, Inc.
  7. Jeffrey Sachs, 1985. "The Dollar and the Policy Mix: 1985," NBER Working Papers, National Bureau of Economic Research, Inc 1636, National Bureau of Economic Research, Inc.
  8. Bennett T. McCallum, 1985. "Monetary vs. Fiscal Policy Effects: A Review of the Debate," NBER Working Papers, National Bureau of Economic Research, Inc 1556, National Bureau of Economic Research, Inc.
  9. Fisher, Franklin M, 1970. "Tests of Equality Between Sets of Coefficients in Two Linear Regressions: An Expository Note," Econometrica, Econometric Society, Econometric Society, vol. 38(2), pages 361-66, March.
  10. Martin S. Feldstein, 1987. "Tax Rules and Business Investment," NBER Chapters, National Bureau of Economic Research, Inc, in: Taxes and Capital Formation, pages 63-72 National Bureau of Economic Research, Inc.
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