[1519] Of fiscal stimulus meets Ricardo

As calls for fiscal stimulus to jumpstart the US economy turn into roars, the White House presented a one-time tax break as a plan.^[1] The plan however failed to convince the market that there is light at the end of the tunnel. Stock exchanges in the US continue to slide down while dragging along other exchanges across the world. Why is that so?

Others have pointed out Friedman’s permanent income hypothesis; temporary change in income does not affect spending. For me on the other hand, David Ricardo comes to mind yet again.

The issue with a temporary tax cut is that it is temporary. The tax cut adds up to the US budget deficit and a knowledgeable rational taxpayer would realize that somebody has to fund that deficit. Thus, the expectation that a tax cut today means an equivalent tax hike in the future. That expectation translate into a scenario which people will save the extra disposable income to pay future hike while consumption stays the same as if there were no change in tax level at all. This is more or less a Ricardian conclusion.

The problem with such reasoning is that individuals may actually appreciate extra cash in their hand in time during times of strained cash flow. The Ricardian conclusion fails to consider temporal discount that people apply to future cash flow. Yet, how many people actually operate their perception of future income in present value?

Regardless, at the moment at least, reality on the ground seems to indicate that one-time tax break might not work, just like in previous cases.^[2]

^[1] — WASHINGTON (Reuters) – Treasury Secretary Henry Paulson said on Friday that the government was considering a $140 billion to $150 billion stimulus package, and swift action was needed to safeguard the economy from a downturn.

[…]

He declined to give specifics on the stimulus package under discussion, but said a significant part would be in the form of tax relief for consumers. [Paulson says mulling $140-150 billion stimulus plan. Reuters. January 18 2008]^[↩]

^[2] — In 2001 — despite the thoroughness and general acceptance of these studies — Congress and the White House once again chose a one-shot tax rebate to deal with an economic slowdown in 2001.

To his credit, Treasury Secretary Paul O’Neill cautioned against the rebate. “I was here when we tried that in 1975, and it just didn’t work,” he said. “If we want to change consumption patterns, we need to make permanent changes in peoples’ tax burdens.” But President George W. Bush overruled his Treasury secretary and approved the rebate idea. Checks of $300 to $600 per taxpayer were sent out in the late summer. Contemporaneous polls by Gallup, Bloomberg and the University of Michigan all found that the vast bulk of consumers expected to save the money or use it to pay bills. Subsequent studies confirmed these forecasts.

In short, there is virtually no empirical evidence that tax rebates are an effective response to economic slowdowns. The increased personal saving doesn’t help the economy because the federal budget deficit, which can be thought of as negative saving, offsets all of it in the aggregate. The main benefit of a tax rebate would seem to be political — giving politicians a way of appearing to be doing something about the nation’s economic problems that is superficially plausible. [Feel-Good Economics. Bruce Bartlett. WSJ. January 19 2008]^[↩]