Thursday, February 12, 2009

REALITY CHECK: Tax cuts are more effective?

"By focusing on grants rather than tax cuts, the Government has rejected a more effective measure."

- Coalition
dissenting report on the economic stimulus package

WHAT'S BETTER? Around $1000 upfront, or a tax cut doled out fortnight by fortnight? That's the core of the economic debate between the Government and the Opposition due to come to a head tonight when the Senate votes on the stimulus package.

The Opposition says tax cuts are better than grants at getting us to spend because they alone boost our "permanent income".

Nobel prize winning economist Milton Friedman developed the idea back in the 1950s. His "permanent income hypothesis" says that what we spend right now depends not on what's in our pockets right now, but on our view of our permanent income - how much we believe will come into our pockets over our lifetime.

Taken to an extreme the thesis suggests that the $12.7 billion in payments now before the Senate would achieve nothing. They wouldn't change our view about the future.

Whereas tax cuts would.

But the $11 billion in tax cuts proposed by the Opposition are unusual...

They would merely bring forward the tax cuts already legislated for June 2009 and June 2010. They too would do nothing to alter anyone's view of their permanent income. Judged by the same standard as bonus payments they too would achieve nothing.

And even if we did get ongoing additional tax cuts, we might not regarded them as permanent. If a government believed that it should cut taxes when things were weak it would probably also believe it should hike taxes when things were strong, also "permanently". Tax changes would no longer be seen as permanent. They would lose their punch.

In the US, bonus payments have packed a surprisingly big punch. For administrative reasons in 2001 and 2008 the bonuses were paid to different people at different times, making it possible to use credit card and other data to tie the timing of spending to the timing of the payments. The findings, in the words of a Federal Reserve Bank of Chicago study, run "counter to the permanent income model".

The thinking is that cash-tight households are unable to spend up big on items such as fridges and shoes when money is dribbled out fortnight by fortnight.

But if they get it in the hand, they can take it to the shops.


Christian Broda, Jonathan A. Parker, The impact of the 2008 rebate, 15 August 2008

John B. Taylor, The State of the Economy and Principles for Fiscal Stimulus, Testimony before the Committee on the Budget, United States Senate, November 19, 2008

Agarwal, Sumit, Liu, Chunlin and Souleles, Nicholas S.,
The Reaction of Consumer Spending and Debt to Tax Rebates - Evidence from Consumer Credit Data, December 2007. NBER Working Paper No. W13694.

David S. Johnson & Jonathan A. Parker & Nicholas S. Souleles, 2004. Household Expenditure and the Income Tax Rebates of 2001, Working Papers 136, Princeton University, Woodrow Wilson School of Public and International Affairs,
NBER Working Paper 10784

Matthew D. Shapiro and Joel Slemrod, Did The 2001 Tax Rebate Stimulate Spending Evidence From Taxpayer Surveys, NBER, September 2002

Gauti B. Eggertsson, Can a tax cut deepen the recession?, Federal Reserve Bank of New York, December 2008