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

No related posts.