Much has been said about Biden’s proposed fiscal stimulus plan that will inject more than $1.9 trillion into the U.S. economy to recover from the economic fallout caused by the pandemic. While economists and international agencies seem convinced of the need for a second fiscal stimulus, little has been said about the long-term fallout that high debt will produce.
Unlike the 2020 Care ACT (which was enacted to provide relief during a period when output was well below potential), the Biden 2021 plan would provide stimulus when the economy is closer to its potential output. While the second shutdowns affected some businesses and individuals, it does not appear that it will reach May’s levels, where more than 22 million people lost their jobs and thousands of businesses closed.
In theory, to stimulate demand in an economy in recession, fiscal spending should be increased, but this is a textbook solution, as its effectiveness and scope vary according to the specific characteristics of each economy.
A U Penn study shows the stimulus plan will hinder the economy
Normally, it is assumed that for every dollar the government transfers to the economy, consumption will rise by a certain percentage. The deeper the recession, the larger the consumption multiplier, in theory. According to a University of Pennsylvania (Penn Wharton) study, each additional dollar toward aggregate demand will generate less additional output in 2021 than in the spring or summer of 2020, when the U.S. economy was farthest from its growth potential.
The problem with Biden’s plan is that government spending will come at the cost of more debt for the U.S. economy. By 2022 government debt will have grown by 7%, causing a substitution of investment in productive capital for increased government debt bond purchases.
Less capital, in turn, decreases the marginal product of labor, which means that each worker has access to less capital resulting in less output per worker. This decrease in output per worker is reflected in lower wages. According to Penn Wharton lower income workers will face a 0.2% decrease in their hourly wages in 2022 and a 0.3% decrease by 2040.
The effect on work is more mixed: while a decrease in hourly wages generally has a small negative effect on hours worked, the increase in tirbutary credits – contemplated in Biden’s stimulus plan – positively affects some low-income households’ incentive to work.
All the stimulus policy provisions result in a 0.1% decrease in total hours worked in 2022. However, the decrease in hours worked fades over time, and there is no change in the total hours worked by 2040.
How will Biden’s stimulus plan affect American citizens?
This plan will affect citizens directly. The fiscal stimulus plan will force the American economy to focus its efforts on paying the debt, instead of investing for the future, which translates into less investment in capital, less investment in research and development, and fewer resources for human capital formation, since much of this money will go to pay for a stimulus whose effectiveness is debatable.
Companies and society, by having to dedicate more money to finance past spending, will have to dedicate fewer resources to becoming more productive. In the end, if an economy’s productivity does not grow, neither will real wages, thus decreasing the purchasing power of all Americans.
A lower capital stock and fewer hours worked would lead to a 0.2% decline in GDP in 2022. However, over time, the decline in capital deepens, leading to a decline in output of 0.3 % by 2040 despite hours worked recovering to their original level.
The decline in output and wages leads to lower government revenues, which according to the Penn-Wharton model would fall by about 0.3% in 2022 and 0.2% by 2040. In both cases, the drop in revenues is due to a reduction in personal wages and Social Security taxes, which are reduced by lower wages.
Part of the drop in personal income and Social Security tax revenues is offset by a small increase in corporate income taxes, which in turn comes from higher corporate income as returns on capital increase over time.