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Saturday, January 19, 2008

"It's an Insult to Keynes"

Bruce Bartlett says temporary tax cuts may not have much of an impact on the economy:

Feel-Good Economics, by Bruce Bartlett, Commentary, WSJ: With remarkable speed, Congress, the White House, Republicans, Democrats and even the Federal Reserve have come to a consensus on the need for economic stimulus... It seems certain that the final stimulus package will contain a tax rebate.

The underlying theory for the rebate idea traces back to the British economist John Maynard Keynes. He believed that spending was the driving force in the economy. It didn't matter whether the spending was done by businesses on capital equipment, by governments on public works, or by consumers -- spending is spending in the Keynesian model, and all of it is stimulative. ...

In the 1960s and 1970s, this usually took the form of public works spending. But in 1974, the White House was keen on the idea of cutting taxes to stimulate private spending. Since it was feared that a permanent tax cut might be inflationary, President Gerald Ford and the Democratic Congress agreed on a one-shot tax rebate. It was thought that cash-strapped consumers would take their government checks and immediately run out and spend them... This would give the economy a Keynesian boost.

One dissenter was economist Milton Friedman. His research had led him to conclude that consumer spending was ... a function of ... "permanent income." ... Friedman predicted that the $100 to $200 checks disbursed ... in the spring of 1975 would have a minimal impact on spending, because they did not alter peoples' permanent income. Most likely, people would save the money or pay down debt, which is the same thing. ...

In 2001 ... Congress and the White House once again chose a one-shot tax rebate to deal with an economic slowdown in 2001.

To his credit, Treasury Secretary Paul O'Neill cautioned against the rebate. "I was here when we tried that in 1975, and it just didn't work," he said. "If we want to change consumption patterns, we need to make permanent changes in peoples' tax burdens." But President George W. Bush overruled his Treasury secretary and approved the rebate idea. Checks of $300 to $600 per taxpayer were sent out in the late summer. Contemporaneous polls by Gallup, Bloomberg and the University of Michigan all found that the vast bulk of consumers expected to save the money or use it to pay bills. Subsequent studies confirmed these forecasts.

In short, there is virtually no empirical evidence that tax rebates are an effective response to economic slowdowns. ... The main benefit of a tax rebate would seem to be political -- giving politicians a way of appearing to be doing something about the nation's economic problems...

A new rebate probably won't do much harm. But anyone who thinks it will prevent a recession -- if one is actually in the pipeline, which is not at all certain -- is dreaming. It's an insult to Keynes even to call a tax rebate Keynesian economics. It should be called "feel good economics" because its only real effect is to make politicians feel good about themselves and buy re-election with the public purse.

I talked about this in early December:

Marty Feldstein says it's time to use both monetary and fiscal policy to deal with the weakness in the economy ... How to Avert Recession, by Martin Feldstein, Commentary, WSJ ...

If we go the temporary fiscal policy stimulus route, which can occur through either an increase in government spending or a decrease in taxes, there is a reason to prefer increased spending. A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. ... In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

So, I agree that we may need to try fiscal policy, but I don't see why temporary tax cuts should be preferred to temporary increases in spending. ...

Bartlett and others are trying to argue that the tax cuts must be permanent in order to be effective. But the effect of permanent tax cuts is not certain. First, tax cuts create an incentive to buy more goods and services, but as noted above, there's no guarantee that will happen, e.g. the money can be used to pay debts instead. Second, permanent is in the eye of the consumer. Politicians can tell people the tax cuts are permanent, but a permanent cut in taxes today today followed by a permanent increase in taxes  tomorrow back where they started is a temporary change. If people believe things will change in the future, or have uncertainties about future policy - and they will - then the permanence of the cut will be in doubt and it will be less effective. Third, permanent tax cuts are not a sustainable countercyclical policy. To be permanent, taxes can never be raised again once they are cut, so eventually, after a few cycles of tax cuts to combat weakness, taxes would be as low as they could go for even an absolute minimal level of government and further cuts will be impossible. Finally, and importantly, the tax cuts that do the most for economic growth in the long-run, the kinds of tax changes you want to make permanent, are very different from the tax policies that cause spending to go up quickly in the short-run to kick start the economy. We shouldn't confuse growth policy with stabilization policy, though some are trying as hard as they can to do just that, cause confusion about the two so they can get permanent tax cuts through using a potential recession as cover.

So permanent tax cuts have a better chance of having an impact on the economy than temporary tax cuts, but there is no certainty about it. Permanent tax cuts are not guaranteed to work. However, as noted above, government spending on public works projects or in other areas will have a predictable initial impact on aggregate demand, it does work. The problem, of course, is timeliness, both in getting spending proposals through congress and in getting the projects up and running quickly. But it's not an impossible task, and since employment effects can linger for some time after the onset of a recession, if some projects take a little more time to get started that isn't so bad. But stimulus is also needed quickly and one way to do that is to simply avoid closing down existing government expenditures at the state and local level. In recessions, state budgets come under pressure and money directed to states can help to avoid having projects discontinued at the state and local level when just the opposite is needed. There are other ways to quickly bolster spending as well, but it takes a congress as committed and amenable to government spending changes to stabilize the economy as this congress is to tax cuts. Given the opposition to using spending rather than tax cuts, it's probably a non-starter for this congress. But unwillingness is not the same as infeasibility.

So, if you must have tax rebates, remember that a tax rebate is just another name for a government transfer payment (e.g. you pay the government $1,000, it rebates or transfers $100 back to you). But tax rebates are not the only kind of transfer payment, and widely distributed tax rebates are not the best way of stimulating the economy. It is possible to get money into the hands of  people, people struggling due to the downturn, where we can be virtually certain that all of it will be spent on goods and services. And many of these programs are already in place, it's simply a matter of enhancing them. Making it easier for people to qualify for unemployment compensation, temporarily extending the time that benefits are paid, temporarily expanding eligibility for food stamps, there are all sorts of programs to get money into the hands of people who are likely to spend it immediately providing a boost to the economy.

There is, of course, one difference between transfer payments and tax rebates. A tax rebate of $100 goes to the person who paid the taxes. A transfer payment may be just that, a transfer from the person paying the taxes to the person receiving the government help. Never mind that it's easy to ensure that the transfer is from rich to poor, or that such transfers are a better means of stimulating the economy than across the board tax rebates, the mere fact that transfers exist is enough to bring opposition from conservatives and block any moves in this direction.

Update: Here's Paul Krugman with similar thoughts:

Stimulus issues, by Paul Krugman: The big problem with attempts to provide temporary economic stimulus is how to ensure that the money gets spent. As Milton Friedman pointed out 50 years ago, consumers tend to base their spending on “permanent income” — the income they expect to have over the long run — rather than their income in any given year. So an $800 check from the Treasury tends, other things equal, to be mostly saved rather than spent.

How does one get around this?

One answer is that not everyone bases spending on permanent income. In particular, people who don’t have a savings cushion and can’t borrow (or can only borrow at high credit-card rates) may be “liquidity constrained,” spending less than they’d like to given their permanent income. For example, a laid-off worker who expects to get another job eventually, but meanwhile is running low on savings, is very likely to spend an extra check.

Another answer is for the government to spend the money directly — or simply refrain from spending cuts that would otherwise happen. For example, state and local governments, which aren’t supposed to run deficits, may be forced to slash spending in a recession; aid to these governments can avert these spending cuts, which is a real plus for the economy.

All of this suggests that if you want a stimulus plan to actually affect demand, it should focus on people likely to be liquidity constrained and on sustaining government spending.

But — you knew this was coming, didn’t you? — it seems that the Bush administration wants to restrict the plan to income tax rebates. This means excluding the people most likely to be liquidity-constrained — because people having a bad year probably won’t owe income taxes that year — and shying away from any aid to direct government spending.

The point is that the debate over exactly how the $145 billion or whatever gets allocated is not, as some might think, a second-order issue. It’s probably at the heart of whether this plan has any real effect.

    Posted by on Saturday, January 19, 2008 at 02:32 AM in Economics, Policy, Social Insurance, Taxes | Permalink  TrackBack (1)  Comments (70)


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    Tracked on Saturday, January 19, 2008 at 07:12 PM


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