Volume CXXXIII, Number 9 November 9, 2001 f

Economic Update: Fiscal stimulus and the "R" word
JOHN FITZGERALD
CONTRIBUTOR

National output declined last quarter and will likely do so again. The "R word." In response to a slowing economy, George Bush has proposed a fiscal stimulus package.

In addition to previously passed emergency spending for disaster relief and tax cuts, the President proposes additional tax cuts of 60 billion for next year plus an additional 15 billion for unemployment insurance. The proposed additional tax cuts include accelerating the individual tax rate reductions already scheduled, eliminating the corporate alternative minimum tax that insures that firms do not completely avoid taxes by taking large expense deductions, and cutting other taxes to encourage business investment in plant and equipment.

The goal of tax cuts and government spending is to increase total spending in the US. When total spending rises, it increases the demand for goods and services and thus stimulates businesses to produce more, hire more workers, and so on. The usual tools are interest rate reductions, government spending increases, and tax cuts. I focus on Mr. Bush's tax cuts and ask whether they are well designed to increase spending quickly.

The effectiveness of tax cuts as a way of stimulating spending depends on whether the cuts are perceived as temporary or permanent. Consumers who get a one time tax cut such as the recent $600 rebate checks are more likely to save a significant portion and not increase spending much today. Current estimates are that families saved about 80 percent of those tax cuts. Uncertain times only add to consumers desire to save. Thus, temporary tax cuts for consumers of the $600 rebate type enacted by Mr. Bush and Congress are unlikely to increase consumer spending by much.

Mr. Bush has also proposed accelerating permanent income tax rate reductions. These are more likely to stimulate consumer spending. The only confounding problem is that the bulk of the tax relief from "across the board" rate reductions go to high income groups since they pay the bulk of taxes. This matters because high income groups tend to save more than lower income groups. To maximize the short term spending the government should direct more tax relief to poorer people by, for example, increasing the Earned Income Tax Credit, a wage subsidy for low income families. But Mr. Bush has not chosen to do this.

On the business side, it turns out that temporary tax cuts have bigger impacts on investment spending than permanent ones. To economists, business "investment" means business purchases of plants and equipment and other physical capital. Evidence shows that business spending on investment responds very slowly (if at all) to permanent tax cuts, but responds quickly to temporary tax incentives. Firms act fast to get the benefits before they disappear.

Businesses can reap tax benefits by accelerating investment plans that they may have already had. For this reason, temporary tax incentives may not have lasting impacts as investment plans return to normal in the future. The House has passed three year temporary business tax cuts. Mr. Bush wants to make them permanent which will undo much of their short term stimulating effect.

Critics deride the repeal of the alternative minimum tax for corporations as a pure giveaway to benefit business. The tax break is retroactive, meaning that it rebates past taxes. Since it is impossible to affect past behavior by actions taken today, retroactive rebates do not seem a promising way to provide current incentives for investment spending. But the giveaway may not be a silly as it sounds. One line of thought, albeit controversial, is that firms' current reluctance to invest is due to poor cash flow relative to debt. When their cash flow increases, they will increase their investment spending. The giveaway does just that: hands them money. Will it work? Past history offers little guidance, but it seems risky since the handout does not have to be spent on investment goods. The alternative of temporary investment tax credits would likely be a better choice.

Most economists agree that some type of fiscal stimulus would be useful today. Most would also agree that temporary tax cuts to consumers and permanent tax cuts to business are the least effective approaches to generate current spending. It appears that politics, as usual, are largely guiding the tax bills with economic stimulus a convenient second thought.