Thursday, August 20, 2009

Why Are (Most) Tax Cuts Less Stimulative Than Spending?

Earlier this week, in "Where Are Those New Ideas?" I looked at some tax policy proposals from Newt Gingrich's advocacy group, Freedom for American Progress in the Future of Liberty and Apple Pie (or something like that). In part, the point of the post (as indicated by its title) was to say that nothing from the man whom even liberal pundits call "the idea guy" could plausibly be called a new or innovative idea. It is all just more attempts to cut taxes on capital and, more broadly, on high income people. At the end of the post, I also pointed out that even the aspect of Gingrich's proposal that seemed to be "populist" -- cutting payroll taxes (Social Security and Medicare) in half for two years -- was actually just a way to rewrite ex post the stimulus bill (which, we must recall, was re-drafted to include large elements of tax cuts in a vain attempt to get broad bipartisan support) to turn spending into yet more tax cuts.

A comment on that post raised a number of very good questions about my working assumptions regarding the relative effectiveness of tax cuts versus spending in dealing with an economic downturn. Here, I will take the opportunity to offer some answers.

"Question 1: Even if the payroll-tax cuts would not go entirely to employees, surely the employers would not stick it under their mattresses. Even if they passively invested some of the money, would that not stimulate employment?"

Following money as it flows through people, businesses, and governments is extremely tricky. It is misleadingly true that since money is never actually destroyed, it is always available to be spent later. The real question, however, is whether it will be spent currently on new goods and services (which is what puts people to work).

True, businesses will generally not systematically pull cash out of the financial system entirely -- although this will happen more often during a crisis than in good times. A business that has received a tax cut can use the money essentially for one of three purposes: (1) Give employees a raise, (2) Expand the business, (3) Put the money into a financial asset (e.g., savings account). During a crisis, options 1 and 2 are especially unlikely. What happens to the money that is put into banks? In good times, the banks will lend the money to businesses or individuals who want to spend it to buy new goods and services. Today, banks have been sitting on the cash. They, in essence, have been sticking it in a mattress called a vault. What little demand there has been for loans has been largely ignored by banks because they are hoarding cash.

"Question 2: Why wouldn't cutting taxes and getting the money directly into consumer's hands be more of a stimulus than what the government is doing now? Isn't it one of the problems of the stimulus plan that it takes too long for the money to get through the system?"

Actually, the government's stimulus spending is working surprisingly well. The slowness in getting some money out the door was partly by (poor) design, as the attempts to mollify critics led to decisions not to spend money on immediately available projects that would have put people to work. What has been done, however, is indeed putting people to work. (Try driving anywhere in the country today without hitting a backup for road repairs.)

Still, why would it not be true that putting money in the hands of non-rich people (through a cut in payroll taxes) would also be immediately stimulative? As I pointed out in the post, it is not at all obvious that the payroll tax cut would actually affect the bottom lines of workers, if businesses are able to capture the tax cut by adjusting gross pay. If the tax cuts do make it into the hands of non-rich people, however, they will be more likely to spend it if they are not worried about losing their jobs. That is why the spending is more effective if it comes directly from the entity that will surely spend and not save the money -- the government.

That is not to say that tax cuts for the middle class are ineffective but that they are less effective than direct stimulus spending. When stimulus spending improves the economic climate, that has the added benefit of encouraging people to spend the tax cuts that they did receive, confident that they can do so without fear of needing that money were they to lose their jobs in a continually weakening economy.

"Question 3: This isn't that great of a point, but I think it is worth mentioning: even if the tax incidence is such that employers reap the majority of the benefits, aren't employers consumers as well? Wouldn't we need a cost/benefit analysis before concluding that one plan is better than the other?"

This is a great point, at least in that it again points out that money from tax cuts does not disappear. Since it does not, where does it go? Employers are, indeed, people who consume. They are overwhelmingly, however, people whose basic consumption needs are already well taken care of. This brings us back to the first point: People who do not need to spend will put their money into banks (or bank equivalents), which will -- in the current environment -- not lend most of it out. The money exists, but it simply sits.

The broader point, that we always need a cost/benefit analysis to determine whether one plan is better than another, is surely right on the mark. This, however, is an area where the costs and benefits are very easy to predict. Especially when the economy is weak, government spending is much more stimulative than tax cuts, and tax cuts that reach non-rich people are much more stimulative than tax cuts that only reach rich people and businesses. It is sad that political constraints have undermined the stimulus package and made it less effective than it otherwise could be, but redirecting the money to business tax cuts (which is, directly or indirectly, what Gingrich is proposing) would make matters much worse.

Thanks for reading.

-- Posted by Neil H. Buchanan