The Fact of My Ignorance

The Trouble with Tax Cuts

Well I’ve had several questions lately about a statement I made in my post CA Obstructionism and Political Games in which I was pretty dismissive of tax cuts in the stimulus bill.  All the questions came via email of course (this is what the commenting system is for guys!  You can comment anonymously if you want!).  Anyway, while I’m planning on writing a much larger treatise on tax policy at some later date, I thought I’d address why I think tax cuts provide for relatively little stimulus.  I’m going to try to keep it as non-technical and conversational as possible.  And I should note before I begin that the principles I’ll present in this post are not universally agreed upon in the field of economics, but they are reflective of the economic philosophies that seem most reasonable to me given my educational experiences, and the views that are most widely held among economists today.  So with that, lets just jump right in, this is the trouble with tax cuts as far as I can tell…

So while I’m going to try to minimize jargon here I’ll have to define one term right at the start, and that’s the “Spending multiplier”.  When you spend a dollar, it actually adds more than a dollar to the economy.  Because that dollar ends up in the pocket of an employee who uses it to pay his rent, whose landlord uses it to buy some groceries, etc etc.  The longer this cycle goes, the more impactful that dollar has been.  And money spent in different ways will multiply at different rates depending on the propensity for that spending method to lead to a cycle like the one described above.  So the spending multiplier is a number that essentially tells us the real GDP increase that one dollar of injected cash will create when spent in a particular way.  So in a stimulus plan, you want to inject as much money as is feasible at the highest spending multiplier possible, so as to increase GDP as much as you can, counteracting our current recession.

So when money is returned to an average person via tax cuts, where does it go?  Well a lot of it is saved.  In fact Nobel Prize winning economist Joseph Stiglitz calculated that less than half of the tax rebates of 2008 were spent in the first 9 months, the rest being saved.  And several things affect this savings rate.  For example when the populace is in an unusual amount of debt, they save a larger percentage of their tax cut.  When there is a lot of uncertainty about the future of the economy or if its expected to decline, they save a larger percentage of their tax cut.  Its also important to note that the rich save a much larger percentage of their tax cuts than the poor, since they require a smaller percentage of their income to pay for basic necessities.

So if we give a dollar in tax cuts, lets say 40 cents right off the bat is put into savings and not sent out to be part of the “cycle of spending” (this is probably a low estimate in today’s economic climate.  Also note that this number would be much higher for the rich and much lower for the poor).  Then of that money spent, a fair portion of it will be spent on foreign products (lets say 40 percent of that – again probably a low estimate) which will go to stimulate that country’s economy and not our own.  So that leaves us with 1*.6*.6 or 36 cents of each dollar of tax cuts that actually goes out into the American economy and is subject to the normal cycle of spending.  This leaves tax cuts with a pretty miniscule spending multiplier.

And of that 36 cents spent, most of it will likely go to credit card companies, grocery stores, and the consumer electronics industries.  Not exactly the industries that most need stimulating right now, and not the industries which are most likely to create more valuable jobs as a result of their income growth.  If only there was a way we could have a tax cut in which all of the returned money was spent, all of the money went to American companies, and most of the money was spent in industries that need it the most.  Well we have something like that, its called government spending.

When the government spends a dollar, none of it is saved, all of it goes to American companies, and we the people (through our elected leaders) can send it to the industries that need it most.  For these reasons, it seems to me that when economic stimulus is your goal, government spending works far better and more efficiently than tax cuts.  Mark Zandi, chief economist for Moody’s Economy.com testified before congress last summer in favor of a stimulus bill and cited these numbers as the calculated spending multiplier for various stimulus options:

Fiscal Bang for the Buck

Source: Moody’s Economy.com

One-year $ change in real GDP per $ reduction in federal tax revenue or increase in spending (ie spending multiplier)

Tax Cuts

Nonrefundable Lump-Sum Tax Rebate————————–1.02

Refundable Lump-Sum Tax Rebate——————————1.26

Temporary Tax Cuts

Payroll Tax Holiday———————————————–1.29

Across the Board Tax Cut—————————————–1.03

Accelerated Depreciation—————————————–0.27

Permanent Tax Cuts

Extend Alternative Minimum Tax Patch————————0.48

Make Bush Income Tax Cuts Permanent————————0.29

Make Dividend and Capital Gains Tax Cuts Permanent——-0.37

Cut Corporate Tax Rate——————————————-0.30

Spending Increases

Extend Unemployment Insurance Benefits———————1.64

Temporarily Increase Food Stamps——————————1.73

Issue General Aid to State Governments————————-1.36

Increase Infrastructure Spending ——————————–1.59

As we can see from this chart two of the very worst methods for stimulating the economy are cutting the corporate tax rate, and making the Bush income tax cuts permanent, two options that have been pushed heavily by some legislators.  Indeed, most of the tax cut options have a spending multiplier of less than one.  So in the instance of the bush tax cuts, of every $100,000 returned through those tax cut programs, $70,000 is basically thrown into a pit as far as the economy is concerned.  This is, in part, because the Bush tax cuts were heavily tilted towards the rich who, as we’ve discussed, save a much larger percentage of their income.  None of this should be a huge surprise since cutting taxes for the rich and big businesses is what we’ve been doing for the last several years, and we’re now in a very sticky situation.

Another interesting thing to note is that one of the most valuable forms of “cutting taxes” is the refundable lump-sum tax rebate, which is used in the recently passed stimulus and which was criticized pretty heavily by pundits.  Also notable is that the various methods of spending increases all provide GDP growth that’s greater than their dollar value.  They also have plenty of non-monetary benefits.  Increasing infrastructure spending, for example, creates jobs and tangible assets (like schools, hospitals, public transportation systems) that will benefit the country for decades.

Of course some people are against government spending for stimulus purposes because they worry about the deficit it would create.  Well I don’t have time to detail the mechanism now but from the numbers listed above we should be able to see that 100 billion in tax cuts will lead to a far greater national deficit than 100 billion of government spending, because the spending will lead to greater GDP growth and larger government receipts, offsetting at least some of the outflows.  Once again, this shouldn’t be a huge surprise considering the deficits we’ve posted the last few years.

We should also remember that if we hadn’t enacted a stimulus plan, and instead attempted to allow the economy to self correct, the recession would have undoubtedly been longer and deeper.  This would lead to a shrunken GDP, which leads to lower Government income, which leads to higher yearly deficits.  So like the bank bailout, the stimulus plan is not a sacrificing of the national debt for expediency, it is an attempt to minimize growth of the national debt over the long term.  The idea is that 800 billion spent now, will prevent a net loss to the government of far more than 800 billion over the next several years.  So its intended to be the path that leads to the smallest growth in national debt, while simultaneously decreasing the economic burden on Americans over the short term, and building infrastructure that will increase jobs and GDP over the long-term.

So that’s the trouble with tax cuts.

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Tags: Economics, Economy, GDP, Government Spending, Growth, Joseph Stiglitz, Mark Zandi, Money, Spending, Spending Multiplier, Stimulus, Tax Cuts, Trouble

This entry was posted on Tuesday, March 10th, 2009 at 8:34 pmand is filed under Political Principles, Politics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

8 Responses to “The Trouble with Tax Cuts”

• Stacey Derbinshire Says:
  March 10th, 2009 at 9:00 pm

  Hi there,

  I looked over your blog and it looks really good. Do you ever do link exchanges on your blog roll? If you do, I’d like to exchange links with you.

  Let me know if you’re interested.

  Thanks..

  Reply
• Mike Harmon Says:
  March 10th, 2009 at 9:00 pm

  Hello.

  I would like to put a link to your site on my blog roll if you want to do the same for mine. It would be a good way to build up both of our readerships.

  thank you.

  Reply
• Tom Humes Says:
  March 10th, 2009 at 9:06 pm

  Nice Site layout for your blog. I am looking forward to reading more from you.

  Tom Humes

  Reply
• Eli Compton Says:
  March 10th, 2009 at 9:09 pm

  I think I got stupider from reading that.

  Reply
• Darryl Pettersen Says:
  March 10th, 2009 at 9:55 pm

  Ryan, I understand the basis of your carefully thought out argument, but I don’t think you have properly evaluated the importance of how increasing the savings rate will directly and indirectly give a boost to the econ0my.  Every dollar saved allows the banking industry to generate 3 to 8 times more dollars loaned (depending the fractional reserve requirements issued by the FED.)  These additional funds available for loans provide the capital for business expansion, residential loans, etc.  We need more saving incentives not less if we are to dig ourselves out of the mess we now find ourselves in.  I do agree that selective injections of government spending can have a positive impact.  For example, we are very close to some major breakthroughs with respect to super-conductivity.  If we (the government) can provide the R&D resources to make these breakthroughs commercially viable, we will be able to make every home an energy producer, rather than a user.  The solar power applications alone of super-conductivity should make the government sit up and take notice.  There are many other examples, too numerous to cite in this short comment, but I think you understand this approach very well.  Keep up the great commentary.  I enjoy your thoughts very much!

  Reply
• Ryan Says:
  March 10th, 2009 at 10:48 pm

  Darryl,  I was wondering if someone was going to bring up the money multiplier!  I would have liked to talk about it in the article since it is such an important element to consider here but it was already going to be so long as it is!  And just to make sure we’re all using the same terms here by “money multiplier” I’m referring to the ratio that tells us the amount of money the banking system generates with each dollar of reserves.  Ordinarily I would agree with you because the money multiplier is normally quite significant.  But obviously the size of the money multiplier is determined by banks propensity to give out loans, and the recent credit crisis has had a significant negative impact on the money multiplier.  See this chart for recent statistics:  http://research.stlouisfed.org/fred2/series/MULT.  

  As you can see the money multiplier is sitting at just below 1.0 right now, on its way back up from a low of somewhere around 0.8 (!).  

  Ordinarily, I think incentivizing savings is important and extremely stabilizing, but I think we have to realize that our banking system is broken right now, and waiting for it to fully recover before addressing these problems is probably not an option.  

  Also, while I added “(ie spending multiplier)” to the chart in my article, I did that only for simplicity.  In reality that number is just a straight calculation of overall impact of each of those options on GDP, so the tax cut calculations listed there include the effect of the money multiplier.  

  So I tried to emphasize in my article that I was talking about why tax cuts were not necessarily beneficial for stimulus purposes under our current circumstances.  Its not intended, of course, to be a sweeping condemnation of tax cuts generally.  And with the credit crisis in full swing, with the money multiplier where it is right now, it seems like incentivizing savings might not be in our best interests at the moment.

  Reply
• December Says:
  March 20th, 2009 at 1:08 pm

  Where you aware that the savings rate in the US is negative? It’s at its lowest rate in history. People aren’t saving their money, they are spending it. Maybe if more people were saving money there wouldn’t be so many people in foreclosures or on assistance from the government.

  Reply
• Ryan Says:
  March 20th, 2009 at 9:43 pm

  Well we have been in the negatives in the recent past, but the savings rate spikes in a recession.  We were up to 3.9 percent last december we’re at 5.0% in January as you can see in this BEA report, and I don’t think the numbers are out for February yet but its likely much higher than that.  Plus tax returns and stimulus checks are treated very differently by the public than their normal expected income and a much higher percentage is saved.

  Anyway, I do agree with the general sentiment of your comment.  I think the low savings rate in this country is certainly deplorable and in normal economic conditions I’m all for incentivizing savings.  And coincidentally President Obama has talked about that very subject pretty extensively.  He believes, and I agree on this point, that we need to move away from a consumption based economy entirely.  I think the money multiplier that Darryl referenced in his comment above is a better and more stable tool for economic stimulus than the “spending multiplier” I talk about in this post, when its working properly.  Unfortunately its not working properly at the moment (as I discussed in my response to his comment).  This article was meant to be a critique of the idea of using tax cuts for stimulus purposes in our current economic situation.

  Like it or not we currently have a consumption-based economy, and our banking system is completely destroyed.  I think we have to pull our economy out before we can restructure it.  We can’t ignore the data.  Incentivizing savings now may be an abstract moral victory, but we’d likely be throwing most of that money away.  Once things start looking up, I agree, we need to raise the federal funds rate, stop worrying so much about GDP growth as the sole measure of economic success, and shoot for a stabler, less consumption based economy.  Fortunately I think that is one of the lessons that will come out of all this.  At least I hope it will be.

  Reply

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