The Agenda

Teasing Out the Broader Implications of ‘the Tax Cut That Failed’

I was very pleased to see Ezra Klein, the Washington Post’s ace policy blogger, write about a new analysis by Matthew Shapiro, Claudia Sahm, and Joel Slemrod of the fiscal stimulus:

 

The Making Work Pay tax credit was built for stealth. Working off of economic evidence suggesting that people are more likely to save a one-time windfall than a small increase in wages, the tax cut was used to lower the amount of tax withholding in people’s weekly paychecks. The hope was that they would spend it, and it would thus do more to stimulate the economy.

This created two political problems for the tax cut. First, it was invisible. A recent CBS/NYT poll showed that fewer than 10 percent of Americans knew Obama had cut taxes. Second, because the administration had a distinct tax-cut design in mind, they added that to the stimulus rather than giving Republicans space to negotiate out a tax-cut portion that they would own. Obama has repeatedly named this as one of his major political mistakes.

Of course, if the tax cut’s design had been much more effective at improving the economy, that would be of more political benefit than headlines or a brief moment of Republican buy-in. But the early research (pdf) on that front is not promising: It looks like it may have been less stimulative than a traditional tax cut. [Emphasis added.]

Let’s think about this for a moment. 

Working off of economic evidence suggesting that people are more likely to save a one-time windfall than a small increase in wages, the tax cut was used to lower the amount of tax withholding in people’s weekly paychecks. The hope was that they would spend it, and it would thus do more to stimulate the economy.

There was also a widely held view that less affluent taxpayers would be more likely to spend, which is why the Making Work Pay Credit was targeted to the less affluent. This has been a central idea in many recent conversations about tax policy, and we now have reason to believe that this isn’t quite right — as we’ll see, it looks as though households make spending decisions in part based on what they believe their incomes will be in the future.

My colleagues at Economics 21 wrote a very helpful post about the new study in late September that highlighted this aspect of the Shapiro, Sahm, and Slemrod research as well as the behavioral findings that were Ezra’s focus:

 

 

The report also challenges another key plank of the Administration’s policymaking: that tax cuts delivered to the poor offer more bang-for-the-buck than tax cuts delivered to the rich. This idea underlies a large number of policy choices, from unemployment insurance extensions to extending the Bush tax cuts for the middle-class but not the rich. Yet the authors find this was not the case for the stimulus program. When considering households that report they will respond to the tax cut by “mostly spending,” the researchers found:

Households who report being worse off financially are almost 7 percentage points less likely to report mostly spending the additional income from any given policy

Interestingly, the authors also find comparable effects for households that expect economic conditions to deteriorate in the future:

A household that expected their income to decline by more than 10 percent over the next year has a mostly-spend rate almost 8 percentage points lower than a household that expects their income to be unchanged

This is plausible if one thinks that poor or struggling households choose to save additional income rather than spend it, a seemingly wise decision. Yet that, in turn, implies that the “multiplier” of spending in response to, say, extensions of unemployment insurance may not be as high as many had projected. Expectations of the future loom large in predicting behavior today. Whether future disposable income is expected to be lower due to tax increases or a deteriorating economy, the natural reaction among households is to reduce spending today. [Emphasis added.]

If these findings prove robust, the implications for how we ought to approach tax policy and fiscal stimulus could prove pretty profound. 

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