All That Matters Is How Fast You Spend The Money

All of Washington is consumed with things stimulatory. But I’ve been puzzled by the policy debate (as opposed to the politics). The conventional logic of stimulus goes something like this. If you provide $1 of federal spending, you get $1 of stimulus. If you enact $1 of tax cuts, you get less than $1 of stimulus because households will save a portion of the lower taxes. Even more damning, unless the tax cuts are permanent, households will save an even greater portion. Since the political class cannot promise any tax cut is really permanent, the upshot is that there is seemingly broad acceptance of the notion that spending is better stimulus than tax cuts. I think this is a dangerous message to send – more on that below – but even more important, I question the logic of the argument.

Let’s begin with the notion that somehow tax cuts are special because households get to deliberate over what to do with the money. If the federal government sets up a fiscal stabilization fund for states, states can decide what next. Likewise if the grants go to a business, it will have the ball on what the first steps will be. Similarly, if there are federal programs, agencies have to decide on regulatory guidance, the process for grants and contracts, and so forth. In short, every dollar of federal tax reduction, increased spending, or transfer to either the private sector or state and local governments will have a behavioral response intervene between the federal budget and the economic impact. Those responses will determine how fast the money gets into the economy and provides stimulus.

And that is the second fuzzy part of the logic. All that matters is how fast you spend the money. It is not a discrete choice between save or don’t save, because people save now to spend later. If a dollar of tax cuts is “saved” and spent in six months, it may still have better and more stimulative effects than $1 of infrastructure that cannot be spent until contracts are signed and the repair season comes around.

Looking at the problem from the perspective of behavioral response the timing of spending puts tax cuts and spending on a level playing field. But what about the inevitability of tax cuts not being permanent? Doesn’t that cinch the case? No. Suppose I hire someone for 1 week to type up all my great thoughts (ok, that will take a lot less time, but you get the point). Does anyone really believe that the temporary job that comes from a temporary spending program will cause the lucky hire to spend all of his or her income? No, they will recognize their temporary good luck and squirrel some of the money away. The same is true of temporary bumps up in federal spending that are slated for extinction. Businesses and workers will recognize that their good luck is temporary and act accordingly.

So, taking the logic of stimulus at face value and looking a bit under the surface, tax cuts and spending programs look more alike than different. But there is one big difference. The federal government already has a spending problem. Indeed the Long-Term Budget Outlook that is regularly issued by the non-partisan Congressional Budget Office (www.cbo.gov) makes very clear the fact that spending is on track to rise from the current 20 percent of GDP to something much closer to 35 percent of GDP. A government that large will truly burden the economy, will require destructive levels of taxation to finance it, and will leave a poor legacy to our children. So, if there is any chance that the stimulus effort might become permanent, it makes little sense to add more spending to our already out-of-control budget situation.

That’s why I think a 1-year, 6.2 percent reduction in the payroll tax should be at the center of discussion. It is a tax that impacts all Americans. Cutting the payroll tax will target the labor market and have real impact on the marginal incentives for employment. And it is large enough that even if some of the cut is “saved” this will simply serve to shore up the weakened balance sheets of households and lower risks facing our banks and financial institutions.