Would tax cuts work?

Sir Samuel Brittan  repeats what for me is becoming a questionable but popular argument:

As for straight tax cuts, there are several ingenious arguments against using them as a stimulus. They boil down to saying that taxpayers will expect taxes to rise again and therefore save most of any windfall. This is the case for concentrating reliefs on poorer citizens who are cash-constrained. It is even more a case for temporary cuts in indirect taxes such as value added tax.

My problem is that focusing tax cuts upon the poor will not necessarily avoid the fact that taxpayers will save any windfall.
For one thing, the idea that the poor have a higher marginal propensity to consume than the rich is questionable. If you owe money to a loan shark, you’ll be more keen to pay down your debts than if you merely owe to Barclaycard. And the very fact that the savings ratio has fallen so much as inequality has risen suggests that the rich or near-rich have a high propensity to consume too.
But even if the poor would spend more of a tax cut than would the rich, it doesn’t follow that tax cuts to them would stimulate the economy. It’s possible that higher earners would react to those cuts by thinking “someone will have to pay for them. And it could be us.” So higher saving by the rich might offset increased spending by the poor*.
Much the same argument applies to cuts in VAT, except with the additional problem that insofar as this does increase spending, some of the benefit will leak out in higher imports.
Even in ordinary times there are loads of examples (pdf) of fiscal policy being counter-productive - of tightenings leading to expansions and easings leading to contractions. But these are not ordinary times. Every scabby dog knows that tax cuts now will mean taxes rises later.  So, if ever there was a time when Ricardian equivalence might hold, now is it.
The chances of an orthodox fiscal expansion working now are, surely, lower than usual.  It might work - though how could we tell? - but we can’t be confident it will. 
So why do it? I suspect because the government feels the need to be seen to be doing something, regardless of its probable effectiveness.
But then, this is true of so many policies.
* For fiscal policy to work, future tax rises will have to be expected to fall upon the poor, not the rich, as I've pointed out.

Comments

[Luis Enrique]

I think you're right - the "cash-constrained" response only works for those so close to the breadline that saving is unthinkable. It seems likely to me that the poor in this country may choose to put something by, or pay down debt, rather than raise consumption, as you suggest.

If fiscal stimulus as in tax cuts doesn't work, what sort of fiscal stimulus does? If we move far above any concept of the natural rate of unemployment, what would you say to state job creation?

[Andreas Paterson]

Surely the best way to look at this is that the idea of future taxes might encourage some level of saving however since no individual has any idea to what extent those taxes might be applied to them. They are also uncertain of their future income and inflation. To that end any Ricardian Equivalence style effect is unlikely to match the level of future taxes.

My view is that most people will continue to spend according to prioritise their own wants and needs over the need to account for potential future taxes.

[dearieme]

"the need to be seen to be doing something": then bring the bloody troops home, you morons.

[Bob B]

I do wonder why John Maples, a deputy chairman of the Conservative Party, found it necessary to apologise "for saying on Monday that the recession should 'take its course'. He told the House of Commons yesterday: 'I realise I may have caused offence to people who are the victims of the recession. I regret that. What I meant, and what I believe, is that the economy cannot recover until levels of private debt have been reduced. I do not believe, and I did not mean to convey the impression, that the Government should not help victims of the recession. I fully support borrowing to do that.'"
http://www.independent.co.uk/news/uk/politics/business-backs-brown-and-darling-1028233.html

[Andrew Lilico]

Chris,

You're certainly correct about the focusing of tax cuts on the poor not getting around Ricardian Equivalence. But where I think you are wrong is in the assertion that now is a particularly strong time to expect Ricardian equivalence. I believe that the opposite is true (and I'm usually a big advocate of Ricd Eqv).

The reason I think you're wrong on this is that at the moment it is plausible that credit provision is materially impaired. That means there will be people out there that would like to borrow to see themselves through recession, should be able to pay back, but are unable to borrow at present. Those people would be helped by tax-cuts-now-tax-rises-later, because such a mechanism effectively allows them to borrow via the government. For everyone else, we have Ricardian equivalence. Hence (admin inefficiency losses aside, assumed small in this case relative to significant credit impairment) there should be a net gain from tax cuts.

[Bob B]

"For everyone else, we have Ricardian equivalence."

Is that claim evidence based or ideologically driven?

Try these links:

The deeper the crisis, the higher the ‘Brown bounce’
http://www.ft.com/cms/s/0/858e0940-b7ed-11dd-ac6d-0000779fd18c.html

Cameron may drown in his clear blue water
http://www.timesonline.co.uk/tol/comment/columnists/anatole_kaletsky/article5192711.ece

[Robert]

Before we get all worked up lets see how much they are offering and to whom.

[Dipper]

but even if everyone simply put their tax cuts in the bank, wouldn't the net effect be that the government had borrowed a load of money and given it to banks, and then they would lend it out? Wouldn't that be a good thing?

[Bob B]

Meanwhile, let's mull on this:

"almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

"'Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,' he told the House Committee on Oversight and Government Reform."
http://www.nytimes.com/2008/10/24/business/economy/24panel.html?ref=todayspaper

As for our Conservatives - where, we are told, 9 out of 10 party members support the Osborne-Cameron line - are we really to believe that no matter how deep and long the anticipated recession, it is inappropriate to budget for a fiscal stimulus to reduce the extent of the recession? If so, then the Conservative policy is rightly tagged as: Do nothing.

That is not the line being taken by the incoming Obama administration in America:

"President-elect Barack Obama sought to bring some relief to Americans anxious about their economic futures, outlining a plan to create 2.5 million jobs with public works programmes that will rebuild roads and bridges, modernise schools and create alternative energy sources. The new recovery plan being developed aims to create millions of new jobs by January 2011. Mr Obama wants Congress to approve it quickly so he can sign it shortly after his inauguration."
http://www.google.com/hostednews/ukpress/article/ALeqM5idbQysXiZkJgARmeGI-wNbbCv4gw

By other news reports this morning, Timothy Geithner is to become US Treasury Secretary while Larry Summers is to replace Ben Bernanke as chairman of the Governors at the Federal Reserve Bank

[Bob B]

There's a repeated argument in national media that since successive fiscal boosts in Japan during the 1990s only chalked up more national debt there and failed to end the stagnation of Japan's economy, the same would apply to a fiscal stimulus in Britain now.

That's a totally dumb play.

It seems not to have occurred to those articulating this argument that: (a) Japan's economy might have become more depressed without the successive fiscal boosts; (b) other factors in Japan weren't equal and could have contributed to the malaise in Japan's economy, sufficiently so to impair the effectiveness of the fiscal boosts.

Try:
http://aparc.stanford.edu/research/causes_of_japans_economic_stagnation/
http://people.ucsc.edu/~hutch/greatstagnation.pdf

There are at least two books on Japan's economy assessing the issues:

MM Hutchinson: Japan's Great Stagnation (MIT Press, 2006)
Jennifer Amyx: Japan's Financial Crisis (Princeton UP, 2006)

I've not read these books and I do wonder whether any of those who trot the argument have read any of the literature.

[Bob B]

Btw here's a British piece by Hamish McRae on the stagnation of Japan's economy (October 2008):
http://www.independent.co.uk/opinion/commentators/hamish-mcrae/hamish-mcrae-can-we-avoid-the-years-of-stagnation-suffered-by-japan-976792.html

[Bob B]

News update:

"WASHINGTON — President-elect Barack Obama has signaled that he will pursue a far more ambitious plan of spending and tax cuts than anything he outlined on the campaign trail — a plan 'big enough to deal with the huge problem we face,' a top adviser said Sunday — setting the tone for a recovery effort that could absorb and define much of his term. . . "
http://www.nytimes.com/2008/11/24/us/politics/24transition.html

"Senior Democrats in the US Congress are considering backing a huge economic stimulus package to try and steer the country clear of recession. Nancy Pelosi, speaker of the House of Representatives, said economists were suggesting a package worth 'several hundred billion' dollars was needed."
http://news.bbc.co.uk/2/hi/americas/7744888.stm

Correction: contrary to earlier US news, Larry Summers is now headed for the post of Director of the National Economic Council and not to replace Ben Benanke, who is the widely respected chairman of the Governors of the Federal Reserve Bank.

[Bob B]

I'm not sure blog readers here are still following this thread but there's an excellent article on Japan's economic problems in Thursday's FT which offers important insights into why all those fiscal boosts to Japan's economy in the 1990s weren't very effective in shaking deflation out of the economic system.

In a phrase, Japan's economy is ossified and greatly needs deregulation:
http://www.ft.com/cms/s/0/4e2f7134-bbf1-11dd-80e9-0000779fd18c.html

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