Tax Cuts vs. Spending Stimuli

This past Tuesday's Wall Street Journal featured an editorial by John B. Taylor, former undersecretary for international affairs and an economics professor at Stanford University, entitled "Why Permanent Tax Cuts Are the Best Stimulus."

As pictures are 'worth a thousand words,' consider the graphic on the left which appeared in Prof. Taylor's piece.

It clearly displays that monthly disposable personal income did, in fact, rise due to the recent 'stimulus' checks, but spending did not.

As Taylor writes,

"The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand, and thereby get the economy growing again. What were the results? The chart nearby reveals the answer.

The upper line shows disposable personal income through September. Disposable personal income is what households have left after paying taxes and receiving transfers from the government. The big blip is due to the rebate payments in May through July.

The lower line shows personal consumption expenditures by households. Observe that consumption shows no noticeable increase at the time of the rebate. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.

These results may seem surprising, but they are not. They correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased, and by a significant amount."

Instead, Taylor recommends that any further economic 'aid' by the government meet three criteria:

"- Permanent. The most obvious lesson learned from the first stimulus is that temporary is not a principle to follow if you want to get the economy moving again. Rather than one- or two-year packages, we should be looking for permanent fiscal changes that turn the economy around in a lasting way.

- Pervasive. One argument in favor of "targeting" the first stimulus package was that, by focusing on people who might consume more, the impact would be larger. But the stimulus was ineffective with such targeting. Moreover, targeting implied that increased tax rates, as currently scheduled, will not be a drag on the economy as long as increased payments to the targeted groups are larger than the higher taxes paid by others. But increasing tax rates on businesses or on investments in the current weak economy would increase unemployment and further weaken the economy. Better to seek an across-the-board approach where both employers and employees benefit.

- Predictable. While timeliness is an admirable attribute, it is only one property of good fiscal policy. More important is that policy should be clear and understandable -- that is, predictable -- so that individuals and firms know what to expect."

When you consider the income, tax and spending expectations and plans of an average American household, it's easy to see why Taylor, and others, are right, while the current Congress and incoming President are wrong to have both pushed the first 'stimulus,' and be planning another $500B spending jolt to the economy.

If someone flies over your home and air-drops a $600 check, then departs over the horizon, you treat the money as a one-time gift. It is, in all likelihood, going to be factored into this year's income and affect spending as an additional percent increase in annual earnings. For a couple earning just $60,000 per year, that's only 1%. Hardly enough to make a big difference, before factoring in a 'marginal propensity to consume,' to use Keynesian lingo.

If, instead, you are told that, effective with this tax year, and henceforth, your tax rates will be lower at each income level by a known amount, you have been given a permanent increase in income. In effect, the government, rather than your employer, has given you a raise.

This results in a much different perspective on the government's economic action. With a permanent earnings increase, more spending is likely. Spending which will also be permanent, resulting in a comparable and permanent expansion in business investment and spending to provide supply for the added consumer demand.

Professor Taylor ends his piece by noting,

"Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market."

So true.

For example, forget the hoary old Keynesian argument that, because governments run deficits, government "pump-priming" will have a greater impact on the economy than the same amount of money in consumers' hands, because consumers have a higher propensity to save than does the government. In Keynes' day, this may have worked, by assuming fixed exchange rates. Not anymore.

In the modern economic environment, large-scale government borrowing will push rates up and currency values down. Maybe not right away in today's context of financial panic, but eventually, it will.

Additionally, government spending of this sort is of the explicitly programmatic, or 'one-off' variety. Not so a permanent cut in tax rates.

So when we hear new plans for an even larger economic 'stimulus' package by Congress and the newly-elected President, you know the end result will be lower-than-expected and/or later-than-expected consumer spending, accompanied by, in time, higher interest rates on the ballooning Federal deficit.

Why don't the new powers in Washington shelve the added governmental spending plans and simply provide real tax rate cuts across all income levels, for both businesses and consumers?