Do Tax Cut And Spending Deficits Have Different Crowd Out Effects?

Abstract

The crowd out effects of government deficits are tested by adding deficit variables to consumption and investment models which extensively control for other factors. Separate variables are added for deficits resulting from tax cuts and spending increases. Effects are calculated for recession and non-recession periods, and compared to models with average crowd out effects for the whole business cycle, and models without crowd out. Test results indicate 1) deficits crowd out private consumption and investment, are statistically significant, and explain substantial variance. They predict “IS” curve coefficients better than no crowd out models. In both recessions and non-recessions, government spending deficits were associated with complete crowd out, leaving no observable net stimulus effect. Tax cut deficits resulted in more than complete crowd out, resulting in net negative economic effects. Both findings are consistent with crowd out theory. Crowd out was found to have roughly equal effects in recessions and non-recession periods. Results are corroborated by independent testing of borrowing data; total declines in private spending were about equal to total declines in borrowing associated with deficits. Financing deficits by monetary expansion may avoid some crowd out problems, but only if the expansion is in the savings components of M2, and occurs in years immediately before the deficit is incurred, limiting its practicality. Foreign borrowing, to supplement domestic savings, can reduce the potential for crowd out.