Introduction

On March 9, 2002, President Bush signed the Job Creation and Worker Assistance Act. The Act included a temporary increase in depreciation allowances for business spending on equipment and software, in the form of 30 percent partial expensing. At the time, the motivation of the Act was that it would provide fiscal stimulus that could help the economy recover from the first recession in a decade. Such fiscal actions are the rule rather than the exception. Indeed, Cummins, Hassett and Hubbard (1994) document that Congress introduced or modified the investment tax credit (ITC) in the majority of postwar U.S. recessions prior to the recent one. Less frequent, but also important, have been discretionary changes in personal income tax rates that are intended to shorten recessions. The tax reduction passed in 2001, for example, was described by its advocates as an "insurance policy" against a long recession. In addition, changes in government fiscal aggregates that are not discretionary--the so-called "built-in stabilizers"--also significantly vary over the business cycle, in a manner that is even more predictable than the periodic discretionary measures.

Such measures introduce important bi-directional interactions between policy and uncertainty. On the one hand, activist policy may heighten the general level of uncertainty in the economy, by adding policy ambiguity to the more fundamental sources of uncertainty. On the other hand, the design of optimal policy itself depends crucially on levels of uncertainty concerning the state of the economy in the short and long run, and the impact of a policy proposal on that uncertainty.

In this paper we discuss recent research that has shed new light on these interactions, proceeding from the short to the long run. We first investigate a number of different channels through which short-run policies can influence the economy. Our analysis gives primary  attention to investment behavior at the outset, because the Permanent Income Hypothesis offers less room for temporary tax policy to change consumption, and because of space constraints. In the first channel, expected changes in tax rates alter the time pattern of the level of the marginal incentive to invest, inducing predictable swings in the level of investment--the "first moment" effect. We discuss in detail a model that allows investigators to identify the direct effect of policy on investment, and describe the relative impact of permanent and transitory policies. We then turn to the question of "automatic" stabilizers, that is, policies that provide a short-term stimulus in downturns that are built in to the tax system. To the extent that these are successful, they can lower volatility and uncertainty in the economy, without introducing new policy uncertainties.

Finally, short run policies often interact in important ways with long run commitments, with large low-frequency imbalances providing "third rail" constraints on the ability of policymakers to pursue countercyclical policies. For example, in the most recent U.S. stimulus debate, many observers argued that the looming bankruptcy of the Social Security system made new tax cuts unwise, while others argued that the imbalances are so uncertain that they can be ignored. Drawing on our recent research (Auerbach and Hassett, 2002) we discuss the impact that constraints on long-run government policy may exert on the nature of optimal countercyclical policy.

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