With the recession entering its second year, President Obama has
called for a large stimulus package that contains a mixture of tax
cuts, new public works projects, and increased government spending
on existing programs. House Democrats have already increased the
size of the stimulus plan from $775 billion to $825 billion while
cutting the amount allocated to tax cuts from $300 billion to $275
billion. While the House leadership may have many reasons for
reducing the tax component of the stimulus package, no doubt one
reason is the ineffectiveness of the rebates of 2001 and 2008
enacted under President George W. Bush.
The one-time rebate issued in the spring of 2008 did not stem
the recession because it did not cause people to spend more. As the
graph below shows, there was a spike in disposable personal income
in May 2008 due to the rebate. But personal consumption expenditure
did not follow suit. According to a paper by Shapiro and Slemrod,
"The official aggregate data on personal saving are broadly
consistent with most of the rebate being saved." They found that most
of the rebate was used to repay debt.
But the rebate checks' lack of success is due to the fact that
they did not increase the marginal incentive to work and because
they did not create any permanent change to individuals' real
These two flaws remain in the centerpiece of President Obama's
tax cuts--an individual tax cut that is refundable and given to
low- and middle-class individuals, a credit equal to 6.2 percent of
up to $8,100 of earnings for the next two years. This means a credit
of $500 per person, or $1,000 for couples per year, effectively
giving individuals $10 more per paycheck every week. This
refundable tax credit accounts for over half of the $275 billion
tax cut allocation in Senate Finance Chairman Max Baucus's
The individual tax cuts proposed by President Obama and the
rebate checks of last year are essentially the same thing, the only
difference being that instead of getting a check in the mail, the
tax cut would be awarded through withholding less from a worker's
paycheck. The idea of using a tax cut instead of a rebate is that
it would allow people to receive the money faster than they would a
rebate, which could take much longer to administer.
Nevertheless, most people make more than $8,100 a year, so most
of the tax relief will not produce an incentive to work more since
once earnings exceed $8,100, the value of the credit no longer
changes. However, a reduction in the marginal tax rate would
increase incentives, especially for lower-income workers.
Supporters for a low-income tax rebate believe that boosting the
income for low-income groups is more beneficial than marginal tax
cuts because lower income groups have a higher marginal propensity
to consume. But empirical studies on previous tax cuts produce a
different conclusion. According to a Federal Reserve Board paper,
"the percent of households that reported spending most of the
proceeds of their tax cuts rises with income, stock ownership,
education, and age.... [T]here is little support for the hypothesis
that liquidity constraints boosted the MPC's [marginal propensity
to consume] of low wealth households." These results are also
consistent with the findings of Shapiro and Slemrod. Even
Paul Krugman, a 2008 Nobel Prize winner, does not think there is
any reason to believe that low-income people can stimulate the
economy more than high-income people can.
Temporary Tax Cuts Are Not
Most people know that this tax cut will last only two years,
just as they knew that last year's rebate check was a one-time
event. They know that in future years, the deficit will have to be
repaid via higher tax rates. This makes workers even less likely to
spend the additional money, because individuals prefer to have a
constant consumption path. The permanent income and life cycle
theories developed by Milton Friedman and Franco Modigliani
respectively say that permanent increases in income increase
consumption considerably more than a temporary increase does,
because the decision to consume depends on an individual's real
wealth, not current real disposable income.
The evidence supports this theory. Economic data from
individuals' and families' consumption patterns over many years
suggests that the marginal propensity to consume from a temporary
tax cut is less than one-third of that from a permanent tax cut. The
forward-looking model, which takes into account how individuals
expect their income to behave in the future, predicts the MPC from
a temporary tax cut being only 5-10 percent of that from a
permanent tax cut.
A Better Way
It is commendable that President Obama wants a sizable portion
of the stimulus package to contain tax cuts. However, the package
should have tax cuts that are the most likely to boost the economy.
A better tax proposal would be to reduce corporate taxes by 10
Too many of the tax cuts in the current stimulus bill would do
little to boost economic growth. For example, one provision that
would extend the net operating loss carryback to five years from
the current law of two years would compensate failing companies
while not providing any new incentive for investment. The same is
true of some of the other proposals that rely on the same failed
reasoning of the Making Work Pay tax credit.
A reduction of 10 percent in the statutory corporate tax rate
for income and capital gains would achieve superior economic
growth. The Joint Tax Committee (JTC) reports that this type of tax
cut would increase investment, which "results in more goods and
services and higher total output. It also results in higher labor
productivity, leading to increased wages and employment." A
more aggressive stimulus bill would be a 20 percent reduction in
corporate rates, which would amount to almost $275 billion in tax
cuts in the first five years.
A Bad Strategy
The tax cuts that are currently part of the stimulus bills and
supported by President Obama are a bad deal. They rely on increased
consumer spending instead of boosting investment and saving.
Similar proposals that rely on the same thinking failed to boost
the economy, and it is unlikely that history will change course
Instead, policymakers should look at enacting tax cuts that will
provide the largest boost to the economy. For $275 billion,
Congress could reduce the corporate tax rate, and that would
increase economic growth for both the short and long run.
Rea S. Hederman, Jr., is
Assistant Director of and a Senior Policy Analyst and Ryan Tang is
a Research Assistant in the Center for Data Analysis at The
Jeannine Aversa, "Obama Stimulus to Include
$300 Billion Tax Cut," Associated Press, January 5, 2009.
Matthew D. Shapiro and Joel Slemrod, "Consumer
Response to Tax Rebates," American Economic Review, Vol. 93, No. 1
(2003), pp. 381-396.
"There's no obvious reason why consumer demand
can't be sustained by the spending of the upper class--$200 dinners
and luxury hotels create jobs, the same way that fast food dinners
and Motel 6s do. In fact, the prosperity of New York City in the
last decade--largely supported off of super-salaried Wall Street
types--is a demonstration that you can have an economy sustained by
the big spending of the few rather than the modest spending of
large numbers of people." Paul Krugman, "Do We Need The Middle
Class?" The New York Times, December 17, 2008, at http://krugman.blogs.nytimes.com/2008/12
/17/do-we-need-the-middle-class/ (January 26, 2009).
According to Charles Steindel of the Federal
Reserve Bank of New York, "if the tax cut is regarded as
transitory, the saving rate should rise at the time of the cut,
because after-tax income will increase but spending will be little
changed.... [D]iffering consumer responses to the 1968, 1975, and
1982 income tax changes indicate that households do indeed
distinguish permanent changes in taxes from temporary ones."
Charles Steindel, "The Effect of Tax Changes on Consumer Spending,"
Current Issues in Economics and Finance, Vol. 7, No. 11, pp.
Ibid.; Blinder (1981) and Poterba
(1988), for example, find an initial MPC of 0.16 to 0.24 as a
result of the one-time tax rebate in the 1975 Tax Reduction Act. On
the other hand, Souleles (2002) found an MPC of 0.6 to 0.9
resulting from the Economic Recovery Tax Act of 1981. For this
summarized data, see Coronado, Lupton, and Sheiner, "The Household
Spending Response to the 2003 Tax Credit."
Coronado, Lupton, and Sheiner, "The Household
Spending Response to the 2003 Tax Credit." The standard reason for
the difference between empirical data and what is predicted by the
forward-looking model is liquidity constraints (see Steindel, "The
Effect of Tax Changes on Consumer Spending," p. 5).