Transfer Payments and the Macroeconomy

...different responses of monetary policy to benefit increases and tax cuts probably explain their very different macroeconomic effects.

Christina Romer and David Romer examine the macroeconomic effects of changes in Social Security benefits in the United States from 1952 to 1991 in their paper Transfer Payments and the Macroeconomy: The Effects of Social Security Benefit Changes, 1952-1991 (NBER Working Paper No. 20087).

During this period, increases in Social Security benefits varied widely in size and timing, and were only rarely implemented in response to short-run macroeconomic developments. As a result, these benefit increases can be used to estimate the short-run macroeconomic effects of changes in transfer payments.

The researchers focus primarily on aggregate consumer spending as a measure of macroeconomic activity. Their estimates suggest a large and immediate spending response following a permanent increase in benefits. In the month of a permanent benefit increase, there is a nearly one-for-one rise in consumer spending. This effect persists for roughly half a year, and then sharply diminishes. Temporary benefit changes, on the other hand, have a much smaller impact on consumption. Broader measures of economic activity, such as industrial production or employment, do not appear to respond to changes in benefits, whether permanent or temporary.

The authors also compare the effects of changes in taxes and transfers on consumption, testing the prediction of Keynesian models in which taxes and transfers have equal and opposite effects on household consumption and overall economic activity. They find that the initial consumption impact of a tax cut is smaller than that of a transfer increase, but that the response to the tax cut rises steadily and persistently. Overall, tax cuts have a much larger impact on consumption than benefit increases. Because their effects on consumption are more persistent, tax changes, unlike benefit changes, do affect broader economic indicators.

What explains the differential response of the economy to these two types of fiscal changes? The researchers suggest that the different responses of monetary policy to benefit increases and tax cuts probably explain their very different macroeconomic effects. The federal funds rate rises sharply and significantly after permanent Social Security benefit increases, but it moves very little, and on average may decline, during the year following tax cuts. Narrative evidence from Federal Reserve records confirms that monetary policymakers regard increases in Social Security benefits as expansionary, and therefore call for tighter monetary policy in response. This feature of the monetary policy reaction could explain both the lower persistence of the consumption effects of Social Security benefit increases, and the absence of an effect on broader indicators of economic activity when these benefits change. In contrast, monetary policymakers were much less consistent in advocating for monetary policy changes that would counteract the likely effects of tax changes on aggregate demand.

-- Claire Brunel