The TC Rule for Fiscal Policy Screams “Lower Taxes and More Spending!”

There has been a bit of noise around the blogs about fiscal rules. Nick Rowe says we should use fiscal policy, even though he means we should have the CB buy stocks or something like that. Matt Yglesias says we should flat out use fiscal policy. Atrios is getting in on the idea too.

A few of us boldly stepped into that dark abyss in the middle of last year. Fiscal policy shouldn’t be an ad hoc, make it up as you go exercise.

We really need to know just how much fiscal to use. So, I proposed a fiscal spending rule to decide the size of the government budget deficit. There are other excellent ways to create rules for fiscal stimulus as well. Carlos has suggested using the unemployment rate to change the level of payroll taxes.

The TC rule right now says – it screams – “WE NEED MORE SPENDING”. In fact, using reasonable numbers, the U.S. Government Budget Deficit should be 13.8%!

The rule itself is pretty simple. It uses our two biggest concerns of employment and inflation, and sets targets for them. It also accounts for population growth, so we can keep per capita GDP growing. It relates these three things to give an amount of deficit spending required to hit these targets.

Here is the rule:

1.8(Uc – Ut) + (It – Ic) + Pop = % (Gt)

1.8 (Current Unemployment – Unemployment Target) + (Inflation target – Current inflation) + Population Growth = Target % Government Deficit

The 1.8 multiplier comes from the well known relationship between employment and GDP called Okun’s Law.  Unemployment varies by 1.8 times the change in GDP, according to recent regressions. To get unemployment down 1%, GDP needs to increase by 1.8%.

Some people are worried about inflation, and I am a bit too. All things considered, I prefer lower inflation to higher inflation.

I suggest using 4% for an unemployment target.  Why? We’ve hit 4.5% and 4% in the last 20 years, and both times we didn’t have much inflation at all.

The suggested target rate for inflation?  4%    Brad Delong is just one of many people who feel a low inflation rate target is harmful because it keeps the economy close to the Zero lower bound for rates.

For the current inflation rate, annualize the last quarter of data. Inflation is a “noisy” series. We could use the last quarter or core inflation, but for now, lets just use the last three months of CPI

In any case, you’ll be hearing much more about these ideas going forward, but for now, let’s just plug the numbers into the TC rule and see what we get.

1.8 (8.5- 4.5) + (4- (0.5))  +1.2 = 13.8%

We should be running a 12.9% Budget Deficit right now according to the TC rule. The projected deficit for next year is 7%  We’re 6% short of where we need to be to get this economy really moving.

4.5% unemployment isn’t an impossible goal, and 4% inflation – well, the inflation rate was higher for an entire 30 year period in the 60’s, 70’s, and 80’s. (I’d show you a chart from FRED, but the inflation chart won’t show up! I think it’s a conspiracy to understate inflation.)


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24 Comments on "The TC Rule for Fiscal Policy Screams “Lower Taxes and More Spending!”"

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Delusional Economics

G’day from Australia.

A good start to what hopefully becomes a daily staple.