Tax Cuts vs. Government Spending

As the Senate and the House look to reconcile competing stimulus plans, the big debate is whether to emphasize government spending or tax cuts. A new paper by the New York Fed’s Gauti Eggertsson argues that the risk of deflation should tilt the balance to government spending.

Our current problem is deficient aggregate demand. The government can raise total spending either by buying more stuff, or it can lower taxes and hope that consumers take their tax breaks to the mall. If consumers do indeed spend their full tax cuts (a big if), you might think that either approach stimulates aggregate demand in roughly equal measure.

But that’s not the whole story. Tax cuts stimulate both aggregate demand and aggregate supply. If taxes are temporarily lower, they make working today more attractive than working tomorrow, and thus increase labor supply. This boost to the nation’s productive capacity means that a tax-cut-based stimulus doesn’t do as much to narrow the gap between output and what we can produce.

Under normal circumstances, this doesn’t present a problem, because the Fed can lower interest rates to close this output gap. But right now, the Fed has set interest rates as low as they can go, and so different principles apply. Eggertsson’s concern is that a big output gap will lead inflation to fall, leading real interest rates to rise in the middle of the recession. These higher real interest rates further dampen economic activity, and with the Fed powerless to offset this, there’s the very real risk of a deflationary spiral. And so a tax-cut-based fiscal stimulus might actually backfire. In fact, Eggertsson reckons there’s a chance that tax cuts could even deepen the recession.

Is Eggertson’s conjecture right? Unfortunately the historical record can’t tell us: there’s never been an episode in which we’ve tried reducing taxes when interest rates were this low. When we’re in uncharted waters, we’ve got nothing but economic theory to guide us. And the theory says it’s safer to stick to a spending-based stimulus plan.

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  1. Jack says:

    How about a $2500 stimulus check per household which has to be used within a month or it disappears. $2000 of that check can only be used to pay down debt and $500 of it has to be used to spend. This will work to help recapitalize banks and lower household debt while also encouraging spending.
    While doing this the govt should continue to purchase MBS and then lower the principal amount on those who are underwater (rather than just the interest rate).
    Then the major banks should continue to pay out bonuses but rather than cash and stock they should pay them out in these toxic assets. This will further help to get these assets off the books and will attract top talent to banks who have realistic valuations on their books.

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  2. Jerry in Chicago says:

    If the problem is jobs–and everyone seems to agree that in a consumer based economy such as ours, jobs is the main problem in a massive downturn–then the solution needs to involve creating jobs.

    The problem with America is we don’t produce much anymore. Thus, giving people tax breaks and extra income will only put more money over seas, via the trade deficit. In other words, we’ll just take our extra money and buy stuff from China.

    The best solution is to create jobs here by building things that we can use for decades. The best thing we could build we be a high-speed train system. Such a system would create thousands, maybe millions, of jobs and make us more fuel effecient. Plus, it’s something we could be proud about. A government owned, high speed train. Very cool. And very needed.

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  3. Brandon says:

    The problem with assuming people will spend any extra money they come into (tax credits or refunds or whatever) is that the government has already cried wolf on this.

    We were given tax credits last year, spent them, and now we’re in a worse spot than we were before.

    Fair or not, intelligent or not, we’re just going to save whatever money we get to save ourselves.

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  4. charles says:

    The historical record wouldn’t prove anything anyway, even if there was a past example with all of the same conditions.

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  5. Brandon says:

    “A government owned, high speed train. Very cool. And very needed.”

    Like Amtrak?

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  6. anonymous says:

    Tastes great / less filling!

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  7. frankenduf says:

    fortunately, the historical record does show what happens with (regressive) tax cuts: less government revenue, infrastructure neglect, increased federal deficits, and the disappearance of a viable middle class economy- Reagan/Bushonomics have come to fruition: throw a party for the rich, with the rest of the citizens left to clean up the mess

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  8. gospazha says:

    Spending? Increasing government spending to over $31,000 for every man, woman, and child in the US? Yes, THAT will help. I *might* be able to stomach this stupid stimulus plan *if* we had ANY inkling of how to pay it off.

    When you’re in a debt hole this big, the first and most important concept is to stop digging.

    We NEED deflation. With the money supply being expanded as fast as the printing presses can churn out dollars for this spending spree Congress is about to take us on, we’re on course for Weimar-like currency value.

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