With monetary approaches like lowering interest rates and multiple, co-ordinated fund infusions having little impact on the ever worsening sub-prime crisis, the US Government is considering a series of fiscal policy measures, aimed at boosting economic activity by increasing short term aggregate demand.
As a first step, President George Bush announced about $145 bn worth tax rebates for American families and incentives for businesses to provide “a shot in the arm to keep a fundamentally strong economy healthy” and avert a slide into recession.
Drawing parallels from the 2001 tax cuts which is claimed to have pushed the US economy into the consumption boom trajectory after the bursting of the tech stock bubble, the Bush administration is contemplating tax rebates to spur consumption and investment. This claim is not backed by both theory and facts, given that the consumption boom was well underway and can be attributed more fundamentally to the historic low interest rates and the "income effect" generated by the real estate bubble that followed. Further, a study of the 2001 tax rebates of $300-600 by Joel Slemrod and Mathew D Shapiro, of the University of Michigan showed that only 22 percent of taxpayers surveyed spent their rebates.
They write, "Instead, they would either save it or use it to pay off debt. This very low rate of spending represents a striking break with past behavior, which would have suggested a much higher rate of spending. The low spending rate implies that the tax rebate provided a very limited stimulus to aggregate demand."
In recent years, especially the two terms of George W, fiscal stimulus has been an alibi for doling out generous tax concessions. And these tax breaks, invariably benefit the rich immediately, while generating deficits that are again used as an excuse to cut down on Government expenditure, especially on welfare.
Though discretionary monetary policy decisions have more immediate impact than fiscal policy decisions, it has been observed that the proximate impact of fiscal policy is on the poorest and struggling families while that of monetary policy is on the financial institutions. Further, monetary policy is more likely to create long term distortions, by raising inflationary pressures and sustaining and even building up excesses. Lawrence Summers argues in favor of a fiscal stimulus, "Fiscal stimulus is appropriate as insurance because it is the fastest and most reliable way of encouraging short run economic growth at a time when a serious recession downturn would pressure American families, exacerbate financial strains, raise protectionist pressures and hurt the global economy."
In fact, the critical determinant of the success or otherwise of any temporary economic stimulus is in getting it spent immediately. Consumers tend to base their spending decisions on what is their "permanent income" or the income they expect to have over the long run, than what they get for one year or a few months. But the poorest, who don’t have a savings cushion, can’t borrow and spend less than what they’d like to given their permanent income, are most likely to spend all the money handed to them in a stimulus, and that too immediately. Another way to get the stimulus spent immediately is for government to spend the money directly or refrain from any spending cuts. State and local government who are most likely to cut their spending during recessions, need to be encouraged to not do so, by providing them assistance.
Eco 101 teaches us that fiscal policy measures during a recession includes supply side measures like corporate tax cuts, so as to incentivize private investment, and demand side steps like personal income tax cuts and Government spending programs. I have serious reservations on measures that seek to stoke demand and supply by reducing taxes, especially given the present context. The bursting of the real estate bubble and the resultant sub-prime mortgage loan crisis has highlighted serious solvency related problems. Such problems cannot be addressed with prescriptions which can solve liquidity related problems.
Personal income tax rebates work well when it puts money in the hands of people who are most likely to spend it. The rich and well off do not certainly belong to that category and will continue to spend, irrespective of any tax rebate. Personal tax rebates are intended to put cash in the hands of consumers, in the hope, and this is the critical determinant, that they will spend it immediately, giving a boost to retail stores, service providers and manufacturers of consumer goods. But history is replete with examples, most recently in Japan, when people facing recessionary expectations and possible interest rate increases, prefer to postpone their consumption and save the additional money put into their hands by the tax rebates or use it to repay debt.
Tax rebates generally benefit the rich disproportionately and becomes less a fiscal stimulus than a sop to the rich and well off - less bang for the buck. A rebate whose size increases for people with larger tax liabilities is likely to be less effective than a uniform refundable one. Further, this would do little to bring in more money into the economy, as the major beneficiaries are in any case indifferent to smaller recessions. In contrast, the lowest income household is most likely to spend all the additional money handed back to it by way of any rebates.
Tax concessions to incentivize business investment are intended to prompt companies to accelerate plans to buy new equipment and factories, and thereby forestall employment losses and even spur new hiring. But faced with a recession, the same devil of "rational expectations" on recession and interest rate increases rears its ugly head in the collective minds of the corporate sector. In any case, corporate sector investment has been already declining since 2004, and is at a historic low, and simple tax rebates will not be able to re-start that engine, without addressing other more deeper underlying causes.
The solvency problems can be ovecome only of the excesses of the bubble days are washed away, and that in turn requires somebody paying the price, most likely the home buyers and the financing institutions. Those bouyed by the "wealth effect" from real estate bubble were important participants in sustaining the consumption boom (even taking it to the high levels of the past 6-7 years) and are the ones most in need of cash. But this category, which is also the most likely group to have spent a significant portion of the rebates on consumption, is now left with no option but to spend the tax rebates in paying off their debts.
Even supply side conservatives, for long supporters ot monetary interventions and opponents of discretionary fiscal stabilizers, are now calling for active fiscal policy interventions. Martin Feldstein recommends a twin strategy of loose monetary policy and fiscal stimulus to reduce the risk of recession. He explains, "What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level."
He finds two benefits in such a stimulus, "First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process."
A Hamilton Project Strategy Paper by Douglas Elmendorf and Jason Furman defines three fundamental desirables in any fiscal stimulus - timeliness, well targeted, and temporary. Based on their respective macroeconomic impact, the authors draw distinction between "taxes and transfers" (eg tax cuts and unemployment insurance expansions) policies designed to increase disposable income and hence consumption, and "government purchases of goods and services" (eg. infrastructure spending) designed to increase spending directly. The authors list of fiscal stimulus options based on their respective bang for the buck
1. Most effective options
a) Extend uneployment insurance (and other) benefits temporarily
b) Temporary increase in food stamps to those already benefitting - would immediately free up incomes for the poor, which can (and most likely to) be then be used for consumption
c) Flat, refundable, equal-sized tax credits for all working households temporarily
d) Aid to local and State Governments, who tend to cut down their spending during recessions
2. Less effective options
a) Increase infrastructure investments - has limited short term impact
b) Temporary investment tax inecentives - has less short term impact, when compared to even individual tax rebates
c) Permanent reduction in tax rates
The Congressional Budget Office (CBO) has more or less the same bouquet of prescriptions on fiscal policy responses to a recession.
In any case, Keynesian demand side management policies may be making a 21st century comeback, and this time it appears to stay on for sometime!
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