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.


Jack

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.

Jerry in Chicago

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.

Brandon

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.

charles

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

Brandon

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

Like Amtrak?

anonymous

Tastes great / less filling!

frankenduf

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

gospazha

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.

M.B.

The bigger problem is hyper-inflation in the out years. It will be like we had in the late 70s early 80s and worse. Print money now, pay later. The best thing the government can do is get out of the way and stop meddling. Government intervention is only needed to stop catastrophic failures, such as banking institutions. Let the car companies go bankrupt if they cannot make it in the market place. Detroit may be down to the big two. If we had government bailouts in the past, we would still be producing carts for horses.

Kathygnome

Like Amtrak?

I think the key would be not like Amtrak. Or at least not like it's current "high speed" service in the northeast, which is not particularly high speed and far more expensive than flying.

jonathan

Those insisting on tax cuts with religious zeal do not accept analysis in a neo-Keynsian framework. They also seem unable or unwilling to accept what "deflation" means.

Jerry in Chicago

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

Like Amtrak?"

You think Amtrak is high-speed? I'm talking 200 miles an hour high-speed, like they have in Europe and Japan.

That kind of train needs it's own tracks. New terminals could be built as well. Scrap Amtrack and use the money on a better system.

ruralcounsel

How about we quit assuming that the economy can be rescued? Maybe it's just a question of crashing, and the question is for how long, and how much deflation will occur?

Might giving the money back to taxpayers to save, so they have some chance of riding out the mess, be the best thing to do with it, rather than have the government dig a deeper debt-hole for our kids?

Brandon

I meant "like Amtrak?" as in "like the federally-owned rail system that hasn't turned a profit in years?"

Brian

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

Thats like saying last year I threw a rock and it started to rain. Not really cause and effect.

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

Some will do this, but others will need to spend the money to pay bills, such as morgage. Plus where will people save the money? I'm guessing that most people will not put it under their mattress. What does not go towards bills or the matress will go into banks or other investments. The real problem is what will happen when the banks get the money, will they keep it or start to make loans?

Brian

I'm just not clear why a tax refund isn't the obvious solution. I would much rather decide where to spend my money than let my congressional rep do it--even assuming they weren't crooks, I would suggest that my spending is more likely to improve the economy than an investment in some silly white elephant project.

You can eliminate the "perverse incentive" of encouraging work by making the cut retroactive: you get a refund off your 2008 taxes but are on your own for 2009.

Likewise, there's no reason to choose a regressive refund--that's just a straw man. A one time, short term, "must be spent by May 1" refund is a far better idea than a 2 year stimulus package loaded down with pork. However, it seems that the latter is what we get.

LCD

"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."

Isn't the whole point of the stimulus to make working more attractive today and to increase the labor supply? If so, then we should have MORE tax cuts.

In fact, the way out of this (in my view) is to substantially reduce cost of investing (i.e., capital gains and double-taxation of dividends). We do that, money floods back into the markets; corporations have a ready currency in their stock; lenders are recapitalized; balance sheets are repaired; and off we go! No need for $400/$800 billion of spending we can't pay off. No need to risk hyperinflation. No need to worry about wasteful government spending and corruption in the allocation of billions of dollars.

It's a shame that actually fixing the problem is not in any politician's interest.

Read more...

Imad Qureshi

I hundred percent agree with you. Spending argument is much more convincing. But your peers at UoC think otherwise.

Steve

What the Rupublicans don't understand or refuse to admit, is that the indescriminate use of tax cuts have created this problem.

When the economy is average, they put money in the hands of those who won't spend it so there is no reason to invest. In bad times, it just allows these same types to cut and run as easily as possible. Remember, even with the stock market down , the beneficiaries of the Reagan tax cuts were into the market when the Dow was 1000 and still have a lot of speculative profits to evade taxes on. They've paid the Republicans a lot of money to get these breaks. Its criminal to call this stimulus.

What is needed is a new tax regimin that gives the breaks to those that make REAL investments. The speculators need (and must) be hammered much harder than they are currently.

Since most wealthy Americans are 2nd, 3rd generation wealth or even further down the food chain, they are hopeless in making real investments. Why cater to these pampered scum any more?

Read more...

Joe D

Brian @16: Perhaps you are capable of using your tax cut to repair crumbling bridges and school buildings, but most of us aren't. Unless you simply consider iterms such as I-35 over the Mississippi River "white elephants."

Of course there's fat in this sausage. It's $800 billion with a "b"; how hard can it be to find a hundred million dollars that's maybe not the wisest possible spending? That's what the right-wing talking points are all about.

I'm also shocked by the Senate's cut of direct funding to states. What happened to "devolution to the states"? My state (FL) is predicting, among other things, huge increases in Medicaid over the next two years. Our (Republican) state government is crying out for some help from Uncle Sugar.