Eggertsson, Gauti B.
Working Paper
What fiscal policy is effective at zero interest rates?
Staff Report, No. 402
Provided in Cooperation with:
Federal Reserve Bank of New York
Suggested Citation: Eggertsson, Gauti B. (2009) : What fiscal policy is effective at zero interest
rates?, Staff Report, No. 402, Federal Reserve Bank of New York, New York, NY
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Federal Reserve Bank of New York
Staff Reports
What Fiscal Policy Is Effective at Zero Interest Rates?
Gauti B. Eggertsson
Staff Report no. 402
November 2009
This paper presents preliminary findings and is being distributed to economists
and other interested readers solely to stimulate discussion and elicit comments.
The views expressed in the paper are those of the author and are not necessarily
reflective of views at the Federal Reserve Bank of New York or the Federal
Reserve System. Any errors or omissions are the responsibility of the author.
What Fiscal Policy Is Effective at Zero Interest Rates?
Gauti B. Eggertsson
Federal Reserve Bank of New York Staff Reports, no. 402
November 2009
JEL classification: E52
Abstract
Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according
to a standard New Keynesian business cycle model. An example of a contractionary
tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it
increases deflationary pressures. Another example is a cut in capital taxes. This tax cut
deepens a recession because it encourages people to save instead of spend at a time
when more spending is needed. Fiscal policies aimed directly at stimulating aggregate
demand work better. These policies include 1) a temporary increase in government
spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than
aggregate supply, such as an investment tax credit or a cut in sales taxes. The results
are specific to an environment in which the interest rate is close to zero, as observed
in large parts of the world today.
Key words: tax and spending multipliers, zero interest rates, deflation
Eggertsson: Federal Reserve Bank of New York (e-mail: gauti.eggertsson@ny.frb.org).
This paper is a work in progress in preparation for the NBER Macroeconomics Annual 2010.
A previous draft was circulated in December 2008 under the title “Can Tax Cuts Deepen the
Recession?” The author thanks Matthew Denes for outstanding research assistance, as well as
Lawrence Christiano and Michael Woodford for several helpful discussions on this topic. This
paper presents preliminary findings and is being distributed to economists and other interested
readers solely to stimulate discussion and elicit comments. The views expressed in this paper
are those of the author and do not necessarily reflect the position of the Federal Reserve Bank
of New York or the Federal Reserve System.
Table 1
Labor Tax Multiplier Government Spending Multiplier
Positive interest rate 0.096 0.32
Zero interest rate -0.81 2.27
1Introduction
The economic crisis of 2008 started one of the most heated debates about U.S. fiscal policy in
the past half a century. With the federal funds rate close to zero — and output, inflation, and
employment at the edge of a collapse — U.S. based economists argued over alternatives to in terest
rate cuts to spur a recovery. Meanwhile, several other central banks slashed interest rates close
to zero, including the European Central Bank, the Bank of Japan, the Bank of Canada, the
Bank of England, the Riksbank of Sw eden, and the Swiss National Bank, igniting similar debates
in all corners of the world. Some argued for tax cuts, mainly a reduction in taxes on labor
income (see, e.g., Hall and Woodward (2008), Bils and Klenow (2008), and Mankiw (2008)) or
tax cuts on capital (see, e.g., Feldstein (2009) and Barro (2009)). Others emphasized an increase
in government spending (see, e.g., Krugman (2009) and De Long (2008)). Yet another group of
economists argued that the best response would be to reduce the government, i.e., reduce both
taxes and spending.
2
Even if there was no professional consensus about the correct fiscal policy,
the recovery bill passed by Congress in 2009 marks the largest fiscal expansion in U.S. economic
history since the New Deal, with projected deficits (as a fraction of GDP) in double digits. Many
governments followed the U.S. example. Much of this debate was, explicitly or implicitly, within
the context of old-fashioned Keynesian models or the frictionless neoclassical growth model.
This paper takes a standard New Keynesian dynamic stochastic general equilibrium (DSGE)
model, which by now is widely used in the academic literature and utilized in policy institutions,
and asks a basic question: What is the effect of tax cuts and gov ernment spending under the
economic circumstances that characterized the crisis of 2008? A key assumption is that the
model is subject to shocks so that the short-term nominal interest rate is zero. This means that,
in the absence of policy interventions, the econom y experiences excess deflation and an output
contraction. The analysis thus builds on a large recent literature on policy at the zero bound on
the short-term nominal interest rates, which is briefly surveyed at the end of the introduction. The
results are perhaps somewhat surprising in the light of recent public discussion. Cutting taxes on
labor or capital is contractionary under the special circumstances the U.S. is experiencing today.
Meanwhile, the effect of temporarily increasing government spending is large, much larger than
under normal circumstances. Similarly, some other forms of tax cuts, such as a reduction in sales
taxes and inve stment tax credits, as suggested for example by Feldstein (2002) in the context of
Japan’s "Great Recession," are extremely effective.
3
2
This group consisted of 200 leading economists, including several Nobel Prize winners, wh o signed a letter
prepared by the Cato Institute.
3
Fo r an early proposal for temporary sales tax cuts as an effective stabilization tool, see for example Mo d igliani
1
The contraction ary effects of labor and capital tax cuts are special to the peculiar environment
created by zero interest rates. This point is illustrated by a nu merical example in Table 1. It
shows the "multipliers" of cuts in labor taxes and of increasing government spending; several
other multipliers are also discussed in the paper. The multipliers summarize by how much output
decreases/increases if the government cuts tax rates by 1 percent or increases government spending
by 1 percen t (as a fraction of GDP). At positive interest rates, a labor tax cut is expansionary,
as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts
become contractionary. Meanwhile, the multiplier of government spending not only stays positive
at zero interest rates, but becomes almost eight times larger. This illustrates that empirical work
on the effect of fiscal policy based on data from the post-WWII period, such as the much cited
and important work of Romer and Romer (2008), may not be directly applicable for assessing
the effect of fiscal policy on output today. Interest rates are always positive in their sample, as
in most other empirical research on this topic. To infer the effects of fiscal policy at zero interest
rates, then, we can rely on experience only to a limited extent . Reasonably grounded theory may
be a better benchmark with all the obvious weaknesses such inference entails, since the inference
will never be any more reliable than the model assumed.
The starting point of this paper is the negative effect of labor income tax cuts, i.e., a cut in
the tax on wages. These tax cuts cause deflationary pressures in the model by reducing marginal
costs of firm s, thereby increasing the real interest rate. The Federal Reserve can’t accommodate
this by cutting the federal funds rate, since it is already close to zero. Higher real in terest
rates are contractionary. I use labor tax cuts as a starting point, not only because of their
prominence in the policy discussion but to highligh t a general principle for policy in this class
of models. The principal goal of policy at zero interest rates should not be to increase aggregate
supply by manipulating aggregate supply incentives. Instead, the goal of policy should be to increase
aggregate demand — the overall level of spending in the economy. This diagnosis is fundamen tal
for a successful economic stim u lus once interest rates hit zero. At zero interest rates, output is
demand-determined. Accordingly, aggregate supply is mostly relevant in the model because it
pins down expectations about future inflation. The result derived here is that policies aimed at
increasing aggregate supply are counterproductive because they create deflationary expectations
at zero interest rates. At a loose and intuitive lev el, therefore, policy should not be aimed at
increasing the supply of goods when the problem is that there are not enough buyers.
Once the general principle is established, it is straightforward to consider a host of other fiscal
policy instruments, whose effect at first blush may seem puzzling Consider first the idea of cutting
taxes on capital, another popular policy proposal in response to the crisis of 2008. A permanent
reduction in capital taxes increases in vestment and the capital stock under normal circumstances,
which increases the production capacities of the economy. More shovels and tractors, for exam-
ple, mean that people can dig more and bigger holes, which increases steady-state output. But at
zero interest rate, the problem is not that the production capacity of the econom y is inadequate.
and Steindel (1977).
2
