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.

Screenshot from real life political computer game: "Take Back Illinois"

Well the Monday night deadline for CA politicians to agree on a budget came and went so Schwarzenegger was forced to send out 10,000 layoff notices to state employees.  The reason for the stall?  They were one vote short in the state senate.  California has a very unusual arrangement that requires a two-thirds majority in both houses of congress for a budget to be passed.  And after months and months of negotiations and concessions to republicans (the bill now consists of millions more in spending cuts than tax hikes) they were only able to entice 2 of the necessary 3 GOP senators to support the bill.

So when everyone woke up the next day and 10,000 more Californians were facing unemployment, did any of the senators who had voted against the bill, have second thoughts?  Did they acknowledge in anyway that thousands of CA families would now be suffering (and not to mention on the unemployment and/or welfare roles of the state) because of their posturing?  Nope.  In fact they gave a big raspberry to bi-partisanship and ousted the senate minority leader who helped negotiate the compromise bill.  The reason for these legislators’ ire?  The bill still contains tax hikes.  Literally, many of them will not vote for the legislation if it contains any tax hikes at all.

Unfortunately, CA is facing a 42 billion dollar deficit that absolutely cannot be fixed by spending cuts alone.  Governor Schwarzenegger recognizes this:

“If you think that you can do this budget without any increase in revenues then you have a big math problem because you can’t erase a $42 billion deficit without revenue increases,” Schwarzenegger said. “I hate taxes, but you when you are faced with that kind of reality, that’s what you have to do. We can only solve this problem with additional revenues and with spending cuts.”

We slashed 11 billion from the budget last year and the current budget has 15.2 billion in further spending reductions in the works.  I don’t think we can cut our way to solvency without unconscionably…canceling basic state services.  I respect the small government perspective, I really do, but now is not the time for extremism on this issue!  If the current budget is passed we will experience the largest reduction in the size of CA government in history as far as I’m aware.  Isn’t that enough?

Of course this isn’t only about tax hikes or spending cuts.  Being the holdout gives you great power and awesome negotiating rights.  You can ask for whatever you want while holding the collapse of the state as your ace in the hole.  And the negotiations began today.  Senators are coming forward and saying they’ll vote for the bill if certain conditions are met.  Sen. Abel Maldonado is one of them.  Does he want some substantive change to the bill?  Does he want lower taxes?  Does he have a new idea for streamlining state government? No, he wants two particular amendments added to the state constitution for him. One of which ironically punishes legislators for not meeting budget deadlines.  Now these amendments may or may not be a good idea but that’s not the point.  What’s upsetting is that Sen. Maldonado and others are using this bill as a lever.  They’re holding out on the budget as a legislative technique, a way to exercise disproportionate power.  He’s putting us at risk so he can try to force the legislature’s hand on an unrelated constitutional issue.  These are the political games I’m talking about.

Of course our state legislators are just mimicking their national counterparts.  After massive concessions were built into our federal stimulus bill (30-something% tax relief when anything over 20% is irresponsible in my book) stimulus opponents complained loudly of lack of input until that number was bumped up to 42% in the senate compromise.  This number was very close to the 46% that Rush Limbaugh proposed for America but it still wasn’t enough!  Republicans knew they could hold out indefinitely and concession after concession would have to be made to appease them, while they could accuse the other side of a lack of bi-partisanship.  When it was apparent that the bill would pass they complained even louder.  They could use even more inflammatory rhetoric now because their opposition had no real world consequences.  It just made them more popular with their conservative base.

Many governors are now in a similar position.  The national governors’ association came out strongly in favor of the stimulus bill but as soon as provisions were added to the bill allowing state legislatures to accept the stimulus funding even if the governor opposed it, governors all across the country started speaking against it.  Because they can now appeal to their conservative base, and come off like small government heros, all the while knowing that their state will receive the federal funds it needs regardless of what they say.

Obviously the Right doesn’t have a monopoly on these methods by any means.  I think to some degree its the natural tendency of the minority party to pull these kinds of stunts.  But I guess I had hoped that in these dire times we would pull together at least to some degree (as we did during september of 2001) and refrain from this kind of posturing.  Instead it feels like while Americans are losing their jobs,  legislators are busy playing a political game that uses our livelihood as the pieces and the media as the board.  And as long as tactics like this are alive and well in American politics, bi-partisanship will continue to be a pipe dream.

No related posts.