A Dam Analogy

Suppose a medication had the following effects: it reduced appetite, made a person more sensitive to light, increased the need for sleep, increased hair growth on arms and legs, and reduced sex drive. Would it be a good diet pill, or would you prefer a medication that only reduced appetite?

Or suppose the government is investigating whether or where to place a dam on a river. The dam might provide flood control to places downstream and electrical power generation. It could affect navigation on the river, and it could create or destroy recreational areas. It could flood valuable farmland or it could create new farmland with irrigation. It would affect wildlife in a variety of ways. Given the many effects of a dam, would you take seriously a proposal to decide dam policy only on the basis of navigation?

A similar situation exists with decisions about tax and expenditure policy. They affect the distribution of income. Some taxes hit the poor hard, while others hit the rich. Some expenditure programs help the poor more than the rich, while others help the rich more than the poor. Both tax and expenditure programs alter the incentives people face and thus alter their behavior. Any change in taxes or expenditures will favor some industries and products while discouraging others. Further, these tax and expenditure policies have not only economic effects, but in altering incentives they can change culture itself. Finally, some economists believe that tax and expenditure policies affect the total level of spending. Given the many effects of tax and expenditure policies, to what extent should they be determined by just one, their effects on total spending? If you think that it would be foolish to determine whether to build a dam by considering only the navigation effects, you should also have doubts about the wisdom of determining tax and expenditure policy based solely on its macroeconomic effects.

Hence, a second problem with discretionary fiscal policy is that its tools do too many things. If we consider the major effect to be the changes in macroeconomic variables, then we have a tool with many side effects. Just as we prefer the medication with the fewest side effects, other things being equal, so too we prefer macroeconomic policy that avoids the complications of side effects. Although monetary policy also has side effects, they are usually much smaller than those of fiscal policy.

A third problem for discretionary fiscal policy involves time lags in implementing it.

Back to OverviewReview QuestionNext
Copyright Robert Schenk