All of Washington is consumed with things stimulatory. But I’ve been puzzled by the policy debate (as opposed to the politics). The conventional logic of stimulus goes something like this. If you provide $1 of federal spending, you get $1 of stimulus. If you enact $1 of tax cuts, you get less than $1 of stimulus because households will save a portion of the lower taxes. Even more damning, unless the tax cuts are permanent, households will save an even greater portion. Since the political class cannot promise any tax cut is really permanent, the upshot is that there is seemingly broad acceptance of the notion that spending is better stimulus than tax cuts. I think this is a dangerous message to send – more on that below – but even more important, I question the logic of the argument.
Let’s begin with the notion that somehow tax cuts are special because households get to deliberate over what to do with the money. If the federal government sets up a fiscal stabilization fund for states, states can decide what next. Likewise if the grants go to a business, it will have the ball on what the first steps will be. Similarly, if there are federal programs, agencies have to decide on regulatory guidance, the process for grants and contracts, and so forth. In short, every dollar of federal tax reduction, increased spending, or transfer to either the private sector or state and local governments will have a behavioral response intervene between the federal budget and the economic impact. Those responses will determine how fast the money gets into the economy and provides stimulus.
And that is the second fuzzy part of the logic. All that matters is how fast you spend the money. It is not a discrete choice between save or don’t save, because people save now to spend later. If a dollar of tax cuts is “saved” and spent in six months, it may still have better and more stimulative effects than $1 of infrastructure that cannot be spent until contracts are signed and the repair season comes around.
Looking at the problem from the perspective of behavioral response the timing of spending puts tax cuts and spending on a level playing field. But what about the inevitability of tax cuts not being permanent? Doesn’t that cinch the case? No. Suppose I hire someone for 1 week to type up all my great thoughts (ok, that will take a lot less time, but you get the point). Does anyone really believe that the temporary job that comes from a temporary spending program will cause the lucky hire to spend all of his or her income? No, they will recognize their temporary good luck and squirrel some of the money away. The same is true of temporary bumps up in federal spending that are slated for extinction. Businesses and workers will recognize that their good luck is temporary and act accordingly.
So, taking the logic of stimulus at face value and looking a bit under the surface, tax cuts and spending programs look more alike than different. But there is one big difference. The federal government already has a spending problem. Indeed the Long-Term Budget Outlook that is regularly issued by the non-partisan Congressional Budget Office (www.cbo.gov) makes very clear the fact that spending is on track to rise from the current 20 percent of GDP to something much closer to 35 percent of GDP. A government that large will truly burden the economy, will require destructive levels of taxation to finance it, and will leave a poor legacy to our children. So, if there is any chance that the stimulus effort might become permanent, it makes little sense to add more spending to our already out-of-control budget situation.
That’s why I think a 1-year, 6.2 percent reduction in the payroll tax should be at the center of discussion. It is a tax that impacts all Americans. Cutting the payroll tax will target the labor market and have real impact on the marginal incentives for employment. And it is large enough that even if some of the cut is “saved” this will simply serve to shore up the weakened balance sheets of households and lower risks facing our banks and financial institutions.
5 responses so far
1 sinz54 // Jan 28, 2009 at 9:20 am
We conservatives have a hard time explaining why it’s better to stimulate the economy generally with tax cuts, rather than hire those unemployed folks directly to do some make-work jobs like the ones in Obama’s stimulus package. The benefits of our approach are more longer-lasting, but take longer to achieve. (The unemployment rate during the Reagan Administration didn’t drop below 7% till his second term.) The Democrats will always point out that cutting taxes doesn’t immediately help anybody who is unemployed for so long that he exhausted his unemployment insurance and now has zero income. We only got away with it in the Reagan administration, because for the first time ever, Americans were more worried about inflation than unemployment and wanted the inflation fixed first. So they tolerated relatively high unemployment rates right through his entire first term. We don’t have that luxury this time.
2 larryo // Jan 28, 2009 at 10:23 am
Taking the last first, a payroll tax cut does not benefit the unemployed, a group which expands geometrically as the consequences of “conservative” economic polices become more and more apparent (as you say, it takes time). Second, we have seen over the past 8 years how “conservative” tax cut policies have not worked for the benefit of the nation as a whole, but only for the benefit of the select few and of the huge corporations. They don’t use the money to invest in “more jobs.” They use it to merge – just what the banks have been doing with the bailout funds that Paulson handed over. But we do have a spending problem. Tell you what: Cut the Pentagon’s budget in half – we will still spend 4 times as much as the rest of the world combined on weapons, and look at the money we’ll save!
3 suey // Jan 28, 2009 at 10:45 am
I would cut defence spending in half ( why do we need super bombers at ridiculous prices anyway?) And use a quarter of it for nation building as against destroying. I give you props Mr Holtz-Eakin for defending the undefendable during the election. There you were on the teeeve day after day giving it the best you have. Tax cuts or spending let’s see, a dollar is taken out of the treasury in a tax cut. That is a dollar you now don’t have to spend. A dollar you tax and then spend on a job creating project then that person actually gets to pay some tax instead of receiving unemployment benefit. Seems like a win/win for the spending to me. OK it will not get cash into the economy as fast but you actually end up with say a bridge or a decent electrical grid for your money.
4 sinz54 // Jan 28, 2009 at 1:41 pm
Larryo & Suey: I suggest you look at the Pentagon’s budget. The bulk of it goes to operations and maintenance, pay and benefits for our men and women in uniform and their families, and so on. Only 20% goes to procurement of new weapons.
(cf. http://en.wikipedia.org/wiki/Military_budget_of_the_United_States)
You actually saw an example of this, when Pentagon spending soared to new heights, yet our troops in Iraq did not have the armored vehicles they needed to defend themselves against Improvised Explosive Devices, the body armor they needed, and other such things. That’s because America has an all-volunteer armed force, and we have to constantly pay a lot to attract young men and women away from civilian life. If you guys on the Left REALLY want to cut defense spending and still have an effective fighting force, you should advocate returning to a military draft. Draftees don’t have to be paid as much, because they have no choice about serving.
5 suey // Jan 28, 2009 at 2:02 pm
I would be happy with a revolving draft on the Israeli model. It might put some spine in our youth. I would though consider shutting many of our overseas bases. We should not be empire builders.
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