“The incoming Obama administration and congressional Democrats are now considering a second fiscal stimulus package, estimated at more than $500 billion, to follow the Economic Stimulus Act of 2008. As they do, much can be learned by examining the first.
The major part of the first stimulus package was the $115 billion, temporary rebate payment program targeted to individuals and families that phased out as incomes rose. Most of the rebate checks were mailed or directly deposited during May, June and July.
The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand, and thereby get the economy growing again. What were the results? The chart nearby reveals the answer.
The upper line shows disposable personal income through September. Disposable personal income is what households have left after paying taxes and receiving transfers from the government. The big blip is due to the rebate payments in May through July.
The lower line shows personal consumption expenditures by households. Observe that consumption shows no noticeable increase at the time of the rebate. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.
These results may seem surprising, but they are not. They correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased, and by a significant amount.
After years of study and debate, theories based on the permanent-income model led many economists to conclude that discretionary fiscal policy actions, such as temporary rebates, are not a good policy tool. Rather, fiscal policy should focus on the "automatic stabilizers" (the tendency for tax revenues to decline in a recession and transfer payments such as unemployment compensation to increase in a recession), which are built into the tax-and-transfer system, and on more permanent fiscal changes that will positively affect the long-term growth of the economy.”
John B. Taylor, “Why Permanent Tax Cuts Are the Best Stimulus”, The Wall Street Journal (25 November 2008).
http://online.wsj.com/article/SB122757149157954723.html
John B. Taylor is professor of economics at Stanford University. He was a member of the President's Council of Economic Advisers during the Ford and George H. W. Bush administrations.
Following a Keynesian prescription to stimulate aggregate demand in a downturn, the first and possibly a second fiscal stimulus package now under discussion are intended to temporarily compensate for the drop in consumer spending caused by the credit crisis of 2008. In this view, the cash received by households would be spent on consumer goods at retail merchants, which would in turn revive wholesalers, shippers and eventually suppliers of the goods and services purchased.
However, consumers may not act in the way assumed by Keynesian economics. The permanent-income hypothesis of Milton Friedman and the Life-Cycle theory of Franco Modigliani suggest that consumers consider their entire future, not just their position at the moment. If they think their future income might be lower than they previously thought, they will lower their current spending, even if their income might temporarily rise. The uncertainty of the present situation and the possibility that the current crisis could portend a significant change in the economy’s long-term performance could well change peoples’ assessment of their future income. Moreover, the stock market decline and the general view that capital assets may well have suffered a permanent deflation could cause a lasting negative “wealth effect”, where the fall in their wealth could lead them to “tighten their belt” and spend less than in the past. Indeed, any temporary injection of income may well be saved as people attempt to rebuilt their wealth position and replenish their saving.
After pointing out the limited response to the first stimulus package and the uncertain impact that any new package of temporary measures might have, Professor Taylor goes on to suggest some bipartisan measures that are, in his words, permanent, pervasive, and predicable:
First, make a commitment, passed into law, to keep all income-tax rates were they are now, effectively making current tax rates permanent. This would be a significant stimulus to the economy...
Second, enact a worker's tax credit equal to 6.2% of wages up to $8,000 as Mr. Obama proposed during the campaign -- but make it permanent rather than a one-time check.
Third, recognize explicitly that the "automatic stabilizers" are likely to be as large as 2.5% of GDP this fiscal year, that they will help stabilize the economy, and that they should be viewed as part of the overall fiscal package even if they do not require legislation.
Fourth, construct a government spending plan that meets long-term objectives, puts the economy on a path to budget balance, and is expedited to the degree possible without causing waste and inefficiency.
In his view, these proposals would be more helpful to the economy than the ideas and policies now being discussed and implemented.]
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