I still have some global warming and jobs report posts in the queue but those require actually looking over some data and ‘thinking’. In the mean time I wanted to get in on some of the stimulus action going around the blogosphere.

I wrote before that I favored a bold and swift fiscal stimulus. I tend to favor payroll tax cuts, not because I don’t think there are good government projects and not because I think taxes are generally too high, but because tax cuts are faster and payroll tax cuts in particular directly target the incentive to layoff labor.

I know that the permanent income hypothesis suggests that people will save rather than spend temporary tax cuts and thus they should be avoided. Empirically, I am not sure that this pans out.

Yes, we know that if we give a big one time rebate the money will not all be spent that month, though importantly some of it will be spent. A more difficult empirical question is how much higher will spending be over the next 6  – 9 months because of such a rebate. An even more difficult question is how much higher will spending be from a full 12 month reduction in taxes.

Theoretically, I think there are some reasons to the think a fair bit of the money will be effectively spent. I say effectively because saving by one person could facilitate spending by another.

  1. People are liquidity constrained. That is, they wish they could borrow more but can’t. Given that most us accept loose lending standards, whatever their ultimate source, as a major cause of the housing boom, this is probably non-trivial. The idea that lending standards affects borrowing rates depends on the notion that there are people who would borrow but are prevented from doing so. Temporary tax cuts allow them to essentially borrow from themselves.
  2. Recessions are associated with higher credit spreads. This implies that there is currently a larger rift between the rate at which individuals can borrow money and individuals as represented by their government can borrow money. Even if you aren’t actually constrained it’s cheaper to take out a loan in the form of a tax cut that you will result it higher taxes later than taking out that same loan directly from a bank. This should encourage spending just as declining interest rates encourages spending.
  3. Defaults increase consumer lending spreads. In a high default environment individuals have to pay more to borrow money. Much of the “savings” that gets done when taxes are temporarily cut is likely to be catching up on late payments. This is especially likely to be true for tax cuts targeted at the poor. Catching up on payments may seem like a non-stimulating use of money but if it lowers credit spreads then it enables other consumers to borrow more cheaply.
  4. People are myopic and use rules of thumb to keep themselves out of debt. That is, if most people borrowed according to their preferences they would borrow themselves deeply into debt. This is because they value near term consumption at an inconsistently high rate. Having preferences that are inconsistent means that following rules of thumb can leave you better off than simple maximization. These rule of thumb might be “only use the credit card for emergencies” or “never borrow to pay for something that will be gone before the debt is paid off.” Those rule, however, don’t typically include “always save your tax cuts.” Thus, tax cuts are spent at rate inconsistent with a pure intertemporal maximizer.