FISCAL STIMULUS IN ECONOMIC UNIONS:

WHAT ROLE FOR STATES

by

Gerald CarlinoFederal Reserve Bank of Philadelphia

Robert InmanUniversity of Pennsylvania

MOTIVATION

FISCAL POLICY IN ECONOMIC UNIONS

The Great Recession and US Fiscal Policy (ARRA)

$797 Billion

$381 B in Tax Relief + $98 B in Federal Purchases + $318 B in State Transfers (48%) (12%) (40%)

LONG RECOGNIZED THAT STATES MIGHT BE IMPORTANT:

BUT HOW?

On Their Own?

When confronted by severe depression state-local governments as a whole have not had andcannot be expected to develop the fiscal ability to expand countercyclical spending. The fewthat are strong enough tend to hold back because expansion or contraction by them can affectthe level of income and employment within their own area to only a limited degree.

As Agents for Coordinated Action by the Federal Government?

Financial assistance from the federal government by grants and loans has been suggested asa technique for getting concerted action by all levels of government.

James Maxwell, Federal Grants and the Business Cycle, p. 100, NBER Fiscal Studies, No. 4, 1952

This Is The Received Wisdom as Delivered by:

Richard Musgrave (Theory of Public Finance)

Wallace Oates (Fiscal Federalism)

THE AGENDA HERE: IS MUSGRAVE-OATES CONJECTURE CORRECT?

OUR CONCLUSIONS

1. From an analysis of state budgets and state economies for the years1973-2009, we find thatstate deficits can improve job growth in the deficit state, but that there are also significantspillovers to “economically neighboring” states.

2. The deficit cost per job created in the deficit state is (on average) about $71,800/job. Including jobs created in economically neighboring states lowers the cost per job to (onaverage) $50,000 per job. Spillovers are significant, statistically and economically. Coordinated fiscal policies are more cost-effective.

3. Intergovernmental fiscal assistance (A) is the most plausible means for a coordinated policy. Current federal assistance is paid to states either as unconstrained (“fungible”) project aid(AP) or as targeted, matching (“price incentive”) aid (AW): A = AP + AW.

4. From an analysis of the impact of A, AP and AW on national income, we find that aggregateaid does positively impact income growth, and that AW assistance is more effective than APassistance. For two reasons. AW aid is a price incentive so money is spent and AW aid istargeted for income and services provided to credit constrained lower income households.

5. The ARRA policy mix might have been 30 percent more effective (or 30% less expensive) instimulating the aggregate economy had only AW assistance been used to stimulate theeconomy.

STEP 1: CAN STATES IMPACT THEIR OWN ECONOMIES?

Estimation of:

( ) = f(OwnD(-1), AP(-1), Spillovers; Controls) + υst, where: N H

OwnD(-1) = State own “cash-flow” deficit lagged one year.

AP(-1) = Federal “unconstrained” aid lagged one year.

Spillovers = Job (or Population Growth) of “Economic Neighbors” lagged one year.

Controls = Changes in world energy prices; changes in state productivity; lagged weather disasters

υst = vt + vs + vst

Estimated for the years, 1973-2009.

OVERVIEW OF ESTIMATES FOR A TYPICAL STATE:

FOR A 1 SD INCREASE IN OwnD(-1) = $390/person will:

L Increase job growth by 1.2% one year later or by 34,000 jobs;

L Increase in-migration implies 7,000 of those jobs filled by in-migrants;

L Increase the aggregate state deficit by $2.44 billion;

L Imply the average cost per job created within the state will be $71,800/job.

BUT IMPACTS ARE SHORT-LIVED

Figure 2

-6

-5

-4

-3

-2

-1

0

1

2

3

1 2 3 4 5 6 7 8 9 10 11

% Change in Job Growth

Years

Figure 2: Responses of State Job Growth to an Increase in State Own Deficits*

Source: Carlino and Inman (2013)

* The solid line represents the time path for changes in the rate of state job growth in response to a 1 percent change in the state's own deficit introduced at the start of year 0. The dashed lines represent the 95 percent confidence band for each year's projected change in job growth.

0

SPILLOVER EFFECTS ARE IMPORTANT, SO FREE-RIDING A RISK

Table 2

REGION FAR WEST

LARGEST JOBS STATE(ΔDeficit/Own Rev)

California(.10)

LARGE STATE’S OWN JOBS (Deficit Cost/Job)

158,483($90,956)

JOB SPILLOVERS TO OTHER STATES (Deficit Cost/Job)

108,561($0)

REGION’S TOTAL JOBS (Deficit Cost/Job)

267,043($53,980)

OTHER STATES’ OWN JOBS (Deficit Cost/Job)

90.301($84,234)

JOB SPILLOVERS TO LARGE STATE (Deficit Cost/Job)

43,836($0)

REGION’S TOTAL JOBS (Deficit Cost/Job)

152,158($49,990)

REGIONAL POLICY JOBS (Deficit Cost/Job)

419,201($52,532)

Source: Carlino and Inman (2013)

THEREFORE:

COORDINATE FISCAL POLICIES THROUGH STATE GOVERNMENTSUSING INTERGOVERNMENTAL AID

AP = Project Aid (Education, Highways, GRS, Model Cities, TANF, TobaccoSettlement)

AW = Welfare Aid (AFDC, Medicaid)

AID = AP + AW

HISTORICAL ALLOCATIONS TO AID

Figure 3

ARRA ALLOCATIONS:

AID = $318 B = $217 B + $101 B = AP + AW

0

500

1,000

1,500

2,000

2,500

1950 1960 1970 1980 1990 2000 2010

$/person

Figure 3Total Aid, Welfare Aid, and Project Aid

Total Aid (A)

Project Aid (AP)

Welfare Aid (AW)

0

1,000

2,000

3,000

4,000

5,000

6,000

1950 1960 1970 1980 1990 2000 2010

$/person

Federal Purchases (G)

Fed Net Revenues (R)

Figure 4Federal Purchases and Federal Net Revenue

Federal Aid, Federal Purchases, and Federal Net Revenue: 1947 - 2010*(Per Capita, 2005 Dollars)

* Recession years shown as shaded bands

* Recession years shown as shaded bands

ESTIMATING THE EFFECTS OF A, AP, and AW on GDP

Impact Estimates:

Wilson (2012)

Feyrer-Sacerdote (2011)

Chodorow-Reich, et. al. (2012)

Dynamic Estimates:

Our Approach using Structural VAR

Tables 3 and 4

TABLE 3:

SVAR Estimates: GDP Responses to Fiscal Shocks for Blanchard-Perotti and Aid Specifications

SpecificationSample Period

Blanchard-Perotti

1947:1 to 2010:3(1)

Blanchard-Perotti

1947:1 to 2010:3(2)

Blanchard-Perotti

1960:1 to 2010:3(3)

Blanchard-Perotti

1960:1 to 2010:3(4)

AidSpecification

1960:1 to 2010:3(5)

AidSpecification

1960:1 to 2010:3(6)

AidSpecification

1960:1 to 2010:3(7)

Fiscal Policy (R - A) G (R - A) G R G A

IMPACT -1.603*(-1.72, -1.47)

.944*(.94, .947)

-1.683*(-1.98, -1.55)

.959*(.95, .96)

-2.804*(-2.84, -2.77)

.564*(.56, .57)

.528*(.52, .53)

4 Qtrs -1.943*( -2.24, -1.65)

.772*(.46, 1.08)

-2.089*( -2.45, -1.72)

1.000*(.59, 1.40)

-3.287*( -3.90, -2.67)

.447(-.24, 1.13)

.713*(.56, .86)

8 Qtrs -1.222*(-1.57, -.87)

.294(-.07, .66)

-1.223*(-1.70, -.75)

.619(.20, 1.03)

-2.186*(-2.96, -1.41)

.404(-.30, 1.11)

.499*(.33, .67)

12 Qtrs -.698(-1.06, -.34)

.023(-.36, .41)

-.578(-1.05, -.11)

.340(-.11, .75)

-1.503*(-2.26, -.74)

.309(-.44, 1.06)

.360*(.18, .54)

20 Qtrs -.235(-.47, .06)

-.071(-.38, .24)

-.0962(-.34, .16)

.058(-.38, .50)

-.920(-1.61, -.23)

.165(-.64, .98)

.234(.04, .43)

Peak -2.105* (Q2) (-2.35, -1.86)

.963* (Q2)(.77, 1.17)

-2.267* (Q2) (-2.55, -1.99)

1.078* (Q2)(.67, 1.41)

-3.755* (Q2) (-4.22, -3.29)

.564* (Q1)(.56, .57)

.802* (Q2)(.68, .93)

TABLE 4:

SVAR Estimates: GDP Response to Fiscal Shocks With Disaggregated Aid Specification

Sample Period 1960:1 to 2010:3(1)

1960:1 to 2010:3(2)

1960:1 to 2010:3(3)

1960:1 to 2010:3(4)

Identification Strategy SVAR SVAR SVAR SVAR

Fiscal Policy R G AP AW

IMPACT -2.955*(-3.06, -2.91)

.807*(.80, .82)

-.108*(-.11, -.11)

1.637*(1.61, 1.66)

4 Qtrs -3.189*(-3.71, -2.67)

.884(.27, 1.51)

.919(.02, 1.78)

2.108*(1.80, 2.42)

8 Qtrs -2.067*(-2.73, -1.40)

.677(.07, 1.28)

.908(.05, 1.77)

1.453*(1.07, 1.83)

12 Qtrs -1.312*(-1.97, -.067)

.498(-.15, 1.15)

.886(-.03, 1.80)

.988*(.58, 1.40)

20 Qtrs -.647(-1.15, -.14)

.301(-.40, 1.01)

.843(-.16, 1.84)

.548(.15, .95)

Peak -3.604* (Q2)(-3.98, -3.23)

.884 (Q4)(.27, 1.50)

1.005 (Q2)(.19, 1.82)

2.315* (Q2)(2.08, 2.55)

INSIDE THE MACRO ECONOMIC BLACK BOX:

RATIONALIZING MACRO MULTIPLIERS WITH STATE FISCALBEHAVIOR

STEP 1: HOW DOES FEDERAL AID IMPACT STATE BUDGETS?

BUDGET IDENTITY:

AP + (rs - b) - (gs + k) / SURPLUS = Δc - Δd + Δf ($504) + ($3063 - $276) - ($3003 + $312) / (-$24) = ($81) - ($55) + (-$50),

b = BC(1 - m)

STATE FISCAL BEHAVIOR

(rs, b, gs, k, Δc, Δd, Δf) = f(AP,1 - m; I, é; c-1; X) + (vt + vs + vst),

(Results in Table 6)

STEP 2: IMPLIED 4-QUARTER MULTIPLIERS FOR FEDERAL AID

For a $1 Increase in Federal Project Aid: ΔAP = 1*

Δrs/ΔAP • .00 ΔB/ΔAP • .02 ΔG/ΔAP • .50 ΔW/ΔAP • .48

Simulated Four Quarter Project Aid (AP) Multiplier

dGDP/dAP = (dGDP/drs)C[Δrs/ΔAP] + (dGDP/dB)C[ΔB/ΔAP] + (dGDP/dG)C[ΔG/ΔAP] + (dGDP/dW)C[ΔW/ΔAP],

.52 = (-3.19)C[.000] + (1.59)C[.02] + (.88)C[.50] + (.10)C[.48]

For a $1 Increase in Federal Welfare Aid: ΔAW = 1 from a small increase in Δm

Δrs/ΔAW = (-52.58)/(135.50) = -.39 ΔB/ΔAW = (95)/(135.50) = .70 ΔG/ΔAW = (-53.30)/(135.50) = -.39 ΔW/ΔAW = (41.30)/(135.50) = .30

Simulated Four Quarter Welfare Aid (AW) Multiplier

dGDP/dAW = (dGDP/drs)C[Δrs/ΔAW] + (dGDP/dB)C[ΔB/ΔAW] + (dGDP/dG)C[ΔG/ΔAW] + [dGDP/dW)C[ΔW/ΔAW],

2.04 = (-3.19)C[-.39] + (1.59)C[.70] + (.88)C[-.39] + (.10)C[.30]

LOOKING FOR THE COST-EFFECTIVE POLICY MIX

ARRA Policy Mix:

ΔR = $45.2 B in 2009:2 ΔG = $11.8 B in 2010:1

ΔAP = $8.7B in 2009:2 and $18.75 B in 2010:1ΔAW = $37.03 B in 2009:2

GDP Growth Over Benchmark With ARRA Policy Mix: 1.95%

Targeted Policy Mix:

ΔR = $57 B in 2009:2

ΔAW = $64.5 B in 2009:2

GDP Growth Over Benchmark With “Targeted” Policy Mix: 2.60%

A LINGERING (Last) QUESTION:

WHY, THEN, USE AP AID?

L TO BE QUICK, LEVERAGE EXISTING UNION POLICIES

L FOR PASSAGE, GIVE STATE POLITICIANS WHAT THEY WANT

Grunwald, The New, New Deal

Boone, Dube, Kaplan, “The Political Economy of ARRA” Brookings Papers

LESSON NO. 1: Musgrave and Oates Were Right,

BECAUSE OF SPILLOVERS, COORDINATED FISCAL POLICIES INECONOMIC UNIONS ARE MOST COST-EFFECTIVE

AN EU FISCAL UNION?

LESSON NO. 2: In Designing Stimulus Fiscal Policy,

IF USING STATES, PRICE INCENTIVES AIMED AT STATE LOWERINCOME ASSISTANCE ARE MOST COST-EFFECTIVE

EU-WIDE SOCIAL INSURANCE?

LESSON NO. 3: But Remember, in a Union Democracy

UNION POLITICS WILL SET UNION POLICIES

EU PARLIAMENT or COUNCIL OF MINISTERS?