Increases in infrastructure spending are not an effective way to provide short-run stimulus to the economy. Rather, monetary policy and automatic fiscal stabilizers would offer the best short-run economic help, and tax and budget policies that increase private business investment would promote long-run growth.

Alan D. Viard is a Resident Scholar at the American Enterprise Institute. The views expressed in this testimony are solely his own and do not necessarily reflect the views of the American Enterprise Institute or any other institution or person.
 
Chairman Rangel, Ranking Member McCrery, Members of the Committee; it is an honor to appear before you today to discuss economic recovery, job creation, and investment in America.

The U.S. economy is experiencing significant difficulties. Although the National Bureau of Economic Research has not yet made an official determination, it is highly likely to eventually declare that the economy entered a recession in late 2007 or early 2008. It is appropriate that this committee consider measures to address the economic distress. Nevertheless, it is imperative that any action be taken in full awareness of its consequences.

Changes in infrastructure spending are not an effective method of creating jobs or providing short-run fiscal stimulus to the economy. As many economists have noted, timing lags make it difficult to deliver the stimulus at the time that it is needed. As a result, changes in infrastructure spending that are intended to stabilize the economy may instead make it more volatile.

Infrastructure spending should be approved if, and only if, such spending would otherwise be economically desirable, based on a comparison of the costs of construction and the benefits from its use. Decisions on infrastructure spending should not be swayed by the illusory hope of job gains or economic stabilization.

While other types of discretionary short-run fiscal stimulus have fewer timing problems than changes in infrastructure spending, most of them are still problematic. Monetary easing and automatic fiscal stabilizers are better suited to serve the goal of economic stabilization. Apart from stimulus concerns, however, Congress can take action to alleviate economic distress by making appropriate adjustments to tax and spending programs.

Even as Congress addresses the current economic difficulties, it is also important to continue to promote long-run growth. Tax and spending policies that promote private business investment are imperative.

1.  Infrastructure construction cannot produce a sustained increase in the levels of jobs or output. 

If more money is spent on infrastructure, more workers will be employed in that sector. In the long run, however, an increase in infrastructure spending requires a reduction in public or private spending for other goods and services. As a result, fewer workers are employed in other sectors of the economy. Attempting to spend more on everything simply bids up prices or interest rates without increasing total employment. 

These remarks apply to the gains from the construction of infrastructure.  The use of well-designed infrastructure can increase the levels of jobs and output, for example when a good road system helps people get to work, and can also improve living standards in other ways. Those arguments for additional infrastructure spending must be evaluated on their own merits.

Of course, this critique applies to all forms of public and private spending, not only to infrastructure spending. For example, it applies to arguments that spending on renewable energy will create "green jobs," that defense spending will create jobs and boost the economy, and that business investment will create jobs though the construction of the investment goods. This critique does not apply to arguments that spending on renewable energy will provide cost-effective energy resources, that a stronger defense will make Americans more secure, and that additional investment will boost future workers' productivity by expanding the capital stock. Those arguments must be evaluated on their own merits.

2.  In theory, a policy of increasing infrastructure spending during recessions (a "countercyclical infrastructure policy") could reduce the severity of recessions and the strength of booms, thereby stabilizing the economy.

The short-run analysis is somewhat different. In the short run, an increase in public and private spending may boost output. Provided that the Federal Reserve does not counteract a desired increase in spending with interest-rate hikes, firms will experience a higher demand for their products. In the short run, firms may choose to expand output and hire more workers rather than to raise their prices. This is a short-run effect that fades away as prices and interest rates adjust.

A decision to increase infrastructure spending could therefore cause a temporary boost in output. There is nothing special about infrastructure in this regard; an increase in any other category of public or private spending would do the same.

A sustained increase in any category of public or private spending would generate a temporary increase in output and employment. It is inconceivable that spending would be boosted for all of eternity merely to obtain a short-run boost to output. If there were no other reason for the spending boost, it would surely prove to be temporary.

What are the effects of a temporary boost to some category of public or private spending? Output rises when the spending increase occurs, but falls when spending returns to normal. Fiscal stimulus measures that boost public or private spending do not "buy" us extra output--they merely "borrow" it from the future.

It is not useful to boost output at one random date and lower it at a later random date. But, it can be useful to boost output when the economy is in a recession and lower it when the economy is booming. Boosting output in today's dire conditions can be useful even though we must eventually "give back" the gains at some later date.

In theory, then, it may be useful to boost infrastructure spending, or some other type of public or private spending, during recessions to provide short-run stimulus. 

3.  In practice, due to timing lags, a countercyclical infrastructure policy would do little to smooth the economy and might well make the economy more volatile. 

Because short-run stimulus merely shifts output and jobs from one time to another, proper timing is essential. If the stimulus arrives after the economy has started to recover, it makes the economy more rather than less volatile.

Federal Reserve chairman Ben S. Bernanke noted the importance of timing in his testimony before the House Budget Committee last week, "To best achieve its goals, any fiscal package should be structured so that its peak effects on aggregate demand are felt when they are most needed, namely, during the period in which economic activity would otherwise be expected to be weak." 

As many economists have noted, this condition is precisely the one that infrastructure spending cannot meet. The time lags built into the spending process are too lengthy to allow the necessary fine-tuning.

In a January 2008 report on stimulus options, the Congressional Budget Office noted:

[B]ecause many infrastructure projects may take years to complete, spending on those projects cannot easily be timed to provide stimulus during recessions, when are typically relatively short lived … Federal, state, and local governments are responsible for large swaths of the economy's capital stock, which includes ports, bridges, and roads. Those responsibilities also include various forms of reconstruction, such as in areas badly damaged by natural disasters. Proposals also exist for large-scale government investment in new technologies, such as new-generation power plants, facilities that produce alternative fuels, and automobiles that use alternative fuels. Conceptually, spending on these kinds of projects seems to offer an appealing way to counteract an economic downturn … Practically speaking, however, public works projects involve long start-up lags. Large-scale construction projects of any type require years of planning and preparation. Even those that are ‘on the shelf' generally cannot be undertaken quickly enough to provide timely stimulus to the economy. For major infrastructure projects supported by the federal government, such as highway construction and activities of the Army Corps of Engineers, initial outlays usually total less than 25 percent of the funding provided in a given year. For large projects, the initial rate of spending can be significantly lower than 25 percent. Some of the candidates for public works, such as grant-funded initiatives to develop alternative energy sources, are totally impractical for countercyclical policy, regardless of whatever other merits they may have. In general, many if most of these projects could end up making the economic situation worse because they would stimulate the economy at the time that expansion was already well underway. (emphasis added)  

In a table summarizing stimulus options, CBO therefore lists "Investing in Public Works Projects" as having "small" cost-effectiveness and a "long" lag from enactment to stimulus.

A similar view is expressed in a January 2008 article by Douglas W. Elmendorf and Jason Furman of the Brookings Institution (Furman is now a senior economic adviser to Senator Barack Obama's presidential campaign): 

[A]dditional physical and technological infrastructure investments … are difficult to design in a manner that would generate significant short-term stimulus.  In the past, infrastructure projects that were initiated as the economy started to weaken did not involve substantial amounts of spending until after the economy had recovered. However this approach might be more useful if policies could be designed to prevent cutoffs in ongoing infrastructure spending (such as road repair) that would exacerbate an economic downturn.

Similar concerns have also been expressed by Alan S. Blinder of Princeton University, who served on President Clinton's Council of Economic Advisers from January 1993 to June 1994 and served as Vice Chairman of the Federal Reserve Board of Governors from June 1994 to January 1996.  In a 2004 paper, Blinder wrote:

The major objections to using public expenditures as a countercyclical weapon seem to be more practical than theoretical.  But I think they are powerful nonetheless … there are normally quite lengthy lags in the political process before new spending projects are authorized by Congress. Then, since authorizing committees and appropriating committees are different, still more time elapses between legal authorization and the actual appropriation of funds … And even if the lags in the authorizing and appropriating processes could be completely eliminated, the slow natural spend-out rates of most public infrastructure projects remains a serious handicap. For example, out of each $1 appropriated for highway expenditures, less than one-third is likely to be spent within a year. Accelerating the pace of spending on public works for stabilization purposes would be inefficient and wasteful. (emphasis in original)

In short, there is a virtual consensus that variations in infrastructure investment are not an effective way to provide short-run stimulus and smooth the economy.

Grants to fund state and local governments' infrastructure projects are likely to pose timing problems even more severe than those posed by federal projects. Even if the grants are disbursed quickly, the disbursement does not provide any stimulus. Stimulus arises only when state and local governments increase their infrastructure spending, creating an additional lag that is largely outside the federal government's control.

Once again, this does not mean that additional infrastructure spending is undesirable. Instead, that determination must be made based on a comparison of the benefits of using the infrastructure and the costs of constructing it. If additional infrastructure is worthwhile, it should be constructed. Such determinations are most likely to be accurate, however, when they are made without the haste associated with an attempt to respond to economic weakness. Infrastructure spending should be properly allocated, with particular care taken to avoid short-changing maintenance. Moreover, even if some infrastructure projects merit additional funding, others should be scrutinized to determine whether their funding is excessive. 

4.  The economy can best be stabilized through monetary policy and automatic fiscal stabilizers.

Other types of fiscal stabilizers may work somewhat better than infrastructure spending, but they are still problematic. Rebate checks may spur some consumer spending, but past studies suggest that the fraction spent is relatively small. A larger fraction of transfer payments to low-income households may be spent, although the small size of the payments typically precludes a large impact on the economy. Furthermore, some of this spending is on imported goods and does not therefore add to demand for U.S. firms. Temporary incentives for business investment can have some impact, but firms are often unable to make large changes in the timing of their investment.

All of these policies also still encounter the difficulty of ensuring timely implementation. The high degree of uncertainty surrounding the future path of the economy makes the appropriate timing of these measures unclear and raises the risk that they will take effect after the economy recovers.

As a result, economic stabilization is generally best achieved through monetary policy and automatic fiscal stabilizers. As Elmendorf and Furman note:

Economists believe that monetary policy should play the lead role in stabilizing the economy because of the Federal Reserve's ability to act quickly and effectively to adjust interest rates, using its technical expertise and political insulation to balance competing priorities … monetary policy should generally be the first line of defense against an economic slowdown.

To be sure, Elmendorf and Furman go on to note, as have other economists, that monetary policy may not always be sufficient, even when combined with automatic fiscal stabilizers, and that additional fiscal stimulus may be "essential" or "helpful."

One concern is that firms and households may not adjust their spending immediately when interest rates fall. Another concern is that the Federal Reserve may be limited in the interest-rate changes that it can make, due to a desire for interest-rate stability or its inability to reduce interest rates below zero.

Nevertheless, it is worth noting that monetary policy has responded aggressively to the current slowdown, as shown in Figure 1. From September 18, 2007 to the present, the Federal Reserve has lowered the federal funds target rate by 375 basis points, from 5.25 percent to 1.50 percent. These reductions began 13 months ago and half of the reductions have occurred within the last 9 months. Although it may take time for the impact of this monetary easing to be felt, it is likely to have a quicker impact than infrastructure spending increases that have not yet occurred.   

Automatic fiscal stabilizers are also significant. When the economy weakens, tax receipts automatically fall and outlays on social insurance and anti-poverty programs automatically rise. Figure 2 shows CBO's computation of the cyclical component of the federal budget deficit or surplus, the change in budget balance that resulted automatically from business cycle conditions. Positive entries mean that business cycle conditions are reducing the federal budget deficit (or increasing the surplus); negative entries mean that business cycle conditions are expanding the deficit (or reducing the surplus). As can be seen, recessions (shown by the shaded areas) have been associated with significant cyclical increases in deficits, often swings of 1 to 2 percent of GDP. The chart further shows that automatic stabilizers have already started to respond to the current economic weakness.  

In summary, monetary easing and automatic fiscal stabilizers are generally the most effective ways to alleviate the economy and such measures are already well under way at this time.

5.  Other policy responses can more effectively alleviate the impact of the economic downturn.

Even if Congress does not adopt discretionary fiscal stimulus, it can and should take measures to alleviate the impact of the downturn. Policies that are appropriate to ensure that resources are efficiently allocated and equitably distributed during economic booms may need to be modified during times of economic weakness. For example, transfer payments may need to be revised to ensure that they are adequate and unemployed workers should be given more time to find a job before losing unemployment benefits; many of the necessary adjustments are made automatically under current law.

Tax policy should also be configured to reflect the different economic conditions. In particular, it may be appropriate to change the treatment of loss deductibility and retirement-account withdrawals.

Current law restricts business firms' ability to deduct net operating losses (NOLs) and individuals' ability to deduct capital losses against ordinary income. Such restrictions are motivated by the concern that reported losses may not be "real"; business losses may reflect deductions that do not reflect real expenses and capital losses may reflect selective sales of assets that have declined in value. Because reported losses are more likely to be real during a downturn, efficiency and equity call for a relaxation of these restrictions.

Current law also penalizes withdrawals from tax-sheltered accounts. These penalties reflect a balance between allowing people to obtain their money when they need it and the desire to promote retirement saving. Because the average taxpayer's need to withdraw the money is likely to be greater during a downturn, the balance should be struck in favor of more lenient rules.

Note that these policies can be justified without regard to stimulus concerns. If they happen to also provide some degree of stimulus, as they might, that is an extra benefit.

6.  Long-run growth can be promoted by tax and budget policies that increase private business investment.

The government exists to serve both the short-run and long-run needs of the American people. Meeting the short-run needs of the American people involves monetary easing, automatic fiscal stabilizers, and recalibration of tax and spending programs to reflect the weakened state of the economy. At the same time, Congress must not lose sight of the need for long-run growth.

The current tax treatment of business investment impedes long-run growth. Corporate investment returns are typically subjected to corporate income tax and also to individual tax (at a 15 percent rate) on dividends and capital gains. As a result, savers cannot capture the full returns from their decision to postpone consumption. Reducing or eliminating the taxation of investment would allow an expansion of the capital stock, which would boost output and wages. Conversely, increased taxation of investment will further retard long-run growth.

To ensure a favorable impact on long-run growth, tax cuts on investment income should not be deficit-financed. Such tax relief can be financed by slowing the growth of entitlement spending. Another desirable approach is a revenue-neutral fundamental tax reform in which the income tax system is replaced by a progressive consumption tax, such as the Bradford X-tax.

Conclusion

Our economy currently faces very difficult times, but short-term fiscal stimulus is probably inappropriate. Even if short-term stimulus is warranted, timing lags make infrastructure spending an unsuitable policy instrument for this purpose. Congress can promote long-run growth by lowering taxes on investment.   

Allan D. Viard is a resident fellow at AEI.

Notes

1. "Economic Outlook," Testimony Before the Committee on the Budget, U.S. House of Representatives, October 20, 2008 (http://www.federalreserve.gov/newsevents/testimony/bernanke20081020a.htm).
2. "Options for Responding to Short-Term Economic Weakness," January 2008, pp.8, 19, 22 (http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf).
3. "If, When, How: A Primer on Fiscal Stimulus," Tax Notes, January 28, 2008, pp. 545-559, at p. 556.
4. "The Case Against the Case Against Discretionary Fiscal Policy," Princeton University, Department of Economics, Center for Economic Policy Studies Working Paper 100, June 2004, pp. 27-28 (http://www.princeton.edu/~ceps/workingpapers/100blinder.pdf).
5. Elmendorf and Furman, supra note 3, p. 545.