In normal downturns, it's usually a bad idea for governments to react aggressively, with either big increases in spending or blanket tax cuts. Better to leave the response to central banks. By lowering the cost of credit, central banks can fight falling demand for goods and services better and faster than parliaments and finance ministries, with their laborious decisions on how much to tax and spend.
But the world is no longer facing a standard downturn. In late September, global markets suffered the monetary equivalent of a heart attack. Governments and central banks reacted with unusual speed and an amazing readiness to learn from each other, providing safety nets for their financial systems, cutting interest rates and using intensive round-the-clock microsurgery to unblock the clogged arteries of money and credit markets.
Despite the drama, such measures cannot restore a healthy flow of credit to households and businesses overnight. The healing takes time. Lower interest rates can stabilize household spending, stimulate business investment and ease debt-service burdens only if the stimulus can pass freely through the financial system. While the system itself is still in intensive care, the money can't flow quickly enough. As a result, it will take longer than usual for the effects of central bank rate cuts to fully kick in. This is the first reason for the major Western economies to consider a fiscal stimulus program in the form of major tax cuts for households and businesses, now. This direct injection of money, of energy and oxygen, can keep the ailing economy going, as it waits for the interest-rate cuts to take effect.
Second, scared savers around the world are rushing into the safest of safe havens, putting their faith into the currencies and the government bonds of the leading Western countries. The heavy buying drives down the interest rate on government bonds, which means that Western taxpayers can borrow collectively through their governments at unusually attractive rates even when they face very tough credit terms individually. In the rare case of a credit crunch on the private economy, such as this one, it can pay to boost demand by borrowing collectively rather than individually.
However, higher public deficits shift the tax burden onto future generations. To be worthwhile nonetheless, a stimulus package needs to meet three criteria: First, it has to work fast—within three to six months. Second, it has to improve the long-term growth potential of an economy, so that future gains in tax revenues make it easier to reduce the public debt again afterward. And third, the package should be structured to minimize the risk that the funds will be hijacked by special-interest groups.
Speed is essential. In the early phase of a recession, economies face the risk of a downward spiral. As households and businesses, concerned about their future amid a mounting avalanche of bad news, curtail their spending, they add to the decline in overall demand for goods, services and labor, which then comes to haunt them again in the form of falling sales revenues and rising unemployment. The earlier this spiral is stopped, the less costly and protracted the recession will be.
In theory, big spending on public investment projects could make sense. But around the world, the track record of these experiments is dismal. Governments and parliaments tend to waste precious time devising the programs, which often fall prey to special-interest groups, resulting in "bridges to nowhere" that offer no help to the economy. In the 1970s for instance, German cities used generous federal aid offered to stave off a recession to build splashy new swimming pools, but soon after had to close many of them because they couldn't afford to pay the lifeguards and other operating costs.
Tax cuts can be passed quickly, leaving special-interest groups less time to interfere. A temporary income-tax reduction, for instance in the form of tax-rebate checks, can help to bridge the time gap before interest-rate cuts start to work. The best tax cuts could also enhance the long-term incentives to work and invest.
The formula will vary by country. Many should cut payroll taxes to put extra spending power into the pockets of workers and businesses immediately. In Germany and France, where payroll taxes raise total wage costs by about 40 percent, with the burden shared by employers and workers, a big cut should have a huge impact.
Because payroll taxes don't apply above certain income thresholds—for example, usually €65,000 per year in Germany—payroll-tax cuts benefit ordinary workers more than the rich. Lower payroll taxes would also reduce the wage bill of each company, helping them to cope with the economic downturn, alleviating the need to fire and making it more profitable for them to hire again once they sense an uptick in demand.
Of course, lower taxes now have to be coupled with future spending restraint. The time to make tough decisions will not end when the economy turns up again. But rarely before has the case for tax cuts to make a recession shorter and shallower been stronger than in today's credit crunch.