Macroeconomic Effects from Government Purchases and Taxes*

For U.S. annual data that include WWII, the estimated multiplier for defense spending is 0.6-0.7 at the median unemployment rate (while holding fixed average marginal income-tax rates). There is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is around 12%. We cannot estimate reliable multipliers for non-defense purchases because we lack good instruments. Since the defense-spending multiplier is typically less than one, greater spending tends to crowd out other components of GDP. The largest effects are on private investment, but non-defense purchases and net exports tend also to fall. The response of private consumer expenditure differs insignificantly from zero. For a sample that begins in 1950, increases in average marginal income-tax rates (measured by a newly constructed time series) have a significantly negative effect on GDP. When interpreted as a tax multiplier, the magnitude is around 1.1. We lack reliable statistical evidence on how the responses to tax changes divide up between substitution effects from changes in tax rates versus income effects from changes in tax revenue. The combination of the estimated spending and tax multipliers implies that, as the median unemployment rate, the estimated balanced-budget multiplier for defense spending is negative. *This research was supported by a grant from the National Science Foundation. We particularly appreciate the assistance with the marginal tax-rate data from Jon Bakija and Dan Feenberg. We also appreciate research assistance from Andrew Okuyiga and comments from Greg Mankiw, David Romer, Jose Ursua, and participants in the Harvard macroeconomics seminar. The global recession and financial crisis of 2008-09 have focused attention on fiscalstimulus packages. These packages often emphasize heightened government purchases, predicated on the view (or hope) that expenditure multipliers are greater than one. The packages typically also include tax reductions, designed partly to boost disposable income and consumption (through income effects) and partly to stimulate work effort, production, and investment by lowering marginal income-tax rates (through substitution effects). The empirical evidence on the response of real GDP and other economic aggregates to added government purchases and tax changes is thin. Particularly troubling in the existing literature is the basis for identification in isolating effects of changes in government purchases or tax revenue on real economic activity. The present study uses long-term U.S. macroeconomic data to contribute to existing evidence along several dimensions. Spending multipliers are identified primarily from variations in defense spending, especially the changes associated with the buildups and aftermaths of wars. Tax effects are estimated mainly from changes in a newly measured time series on average marginal income-tax rates from federal and state income taxes and the social-security payroll tax. Some of the results attempt to differentiate substitution effects due to changes in tax rates from income effects due to changes in tax revenue. Section I discusses the U.S. data on government purchases since 1914, with stress on the differing behavior of defense spending and non-defense purchases (by all levels of government). The variations up and down in defense outlays are particularly dramatic for World War II, World War I, and the Korean War. Section II describes a newly updated time series from 1912 to 2006 on average marginal income-tax rates from federal and state individual income taxes and the