Sunday, January 18, 2009

Temporary Tax Cuts

As the NYT reports, House Democrats released a tax plan on Friday with $275 billion in cuts in an effort to revive the economy.
But the tax provision likely to be of most interest is the two-year middle-class tax cut, which will provide up to $500 to individuals and up to $1,000 for couples earning less than $200,000 a year, the overwhelming majority of Americans.
Let's ignore normative questions surrounding the government's role in stimulating the economy and, instead, focus on the economic case: will temporary tax cuts boost aggregate demand?

The short answer is no. As the Life Cycle Hypothesis (developed by Modigliani and Fisher, among others) and Permanent Income Hypothesis (developed by Friedman) suggest, temporary changes in income have little effect on current consumption. The idea is that individuals smooth out consumption over the long run.

Let's make some rough calculations.
Δ Current Consumption = Δ Income/n

where Δ represents "change in" and n is the remaining number of years one expects to live.
Assuming the average recipient is 45 years old and expects to live until they are 78, n = 33. A temporary tax cut of $275 billion increases aggregate current consumption by $275b/33 = $8.33 billion. Of course, if you are anything like me, the word billion after any number reduces the entire value to "a lot". To clarify: a tax cut of $500 per person for two years would boost current consumption by $(500+500)/33 = $30.30 per person. I've had bigger bar tabs.

It might be unfair to leave the discussion at this point, though. The assumption implicit in the Life Cycle Hypothesis/Permanent Income Hypothesis is that individuals save in good times and dissave or borrow in bad times. It could be argued that the government is simply providing short-term credit to those who would dissave or borrow if they had savings to dip into or private lenders willing to make loans. If this is the case, we should expect a larger portion of the tax cut to affect current consumption.

At best, though, I think the government-as-lender idea opens up a can of worms. For example, how does the government know who would be willing to take out a loan? The decision to give tax cuts to everyone "earning less than $200,000 a year, the overwhelming majority of Americans" seems to suggest they don't know with any significant degree of precision. So even if one were to accept this line of thinking, a temporary tax cut is a particularly inefficient modus operandi.

[Please refrain from jokes about two-handed economists, as appropriate as they may be.]

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