Economy: Why Tax Cuts Won't Work

The congressional debate over the stimulus package may be over, but the larger debate isn't. Many critics of the bill, which contains a mix of tax cuts and government spending, believe that the government spending part just won't work. Thirty-six of the 41 members of the Republican Senate minority voted for an amendment by Sen. Jim DeMint of South Carolina that called for a stimulus package consisting only of tax cuts. Economists whose sympathies lie with the Republicans have backed up the cut-taxes/don't-spend approach. Robert Barro of Harvard, speaking to the Atlantic, called the stimulus package "probably the worst bill that has been put forward since the 1930s." The government spending proposed wouldn't work as intended, he argued. Instead, we should cut tax rates. Harvard economist Greg Mankiw, a former Bush adviser, expressed his preference for a stimulus that would immediately and permanently end payroll taxes, to be offset by an increase in gas taxes.

Adherents of the tax-cuts-only strategy are suspicious of free-spending Democrats, old-fashioned Keynesians, and big government. They believe—no, they know—that tax cuts are more efficient than government spending, since people and businesses make better and quicker decisions about spending than government does. And the way they read the relevant data, history, and experience, permanently reducing long-term tax rates has historically provided the best possible incentives to invest and spend. They may be right. But there are also reasons to think that what worked or made complete sense in the past may not be as effective today. The current, somewhat extraordinary circumstances, and the nation's changing economic geography, should make us wonder how effective tax cuts will be in stimulating new spending and investment.

Let's say you're a tenured professor of economics at Harvard. You have—and have earned—a great deal of stability and security. Your job is guaranteed, at pretty much the same salary, until retirement. Your employer, which has been around for more than 350 years, isn't going anywhere. The university provides nice health care benefits and contributes generously to a retirement plan. All of which means you can make pretty good plans about your short- and long-term financial future. If we reduce payroll taxes—or eliminate them entirely—the professor will have an extra $200 in his paycheck every month. And that might yield predictable results. Feeling slightly more flush, he might be more likely to amble down to the Coop and buy a few books or a V-neck Crimson sweater or to invest in a summer home on Cape Cod. That's what a rational person would do. And that would stimulate the economy nicely.

Back in the day, and in many of the past episodes of postwar recession, the typical American worker resembled a Harvard professor—not in brains or wit, to be sure, but in the shape of her economic life. Many—not all, but a lot—enjoyed long, relatively secure job tenures, steady incomes, and generous employer-provided health and retirement benefits. But the economy has changed significantly in recent decades. And the circumstances that might prod our professor to start spending those tax cuts immediately might not apply to everybody else. The typical worker—white-collar, blue-collar, no-collar—doesn't have anything like tenure or a guaranteed job. In fact, she may be working at a company that has just laid off 10 percent of its work force and may soon lay off more. She may be one of the 3.6 million people who has lost a job in the last year. She may work in an industry in which one large, longtime player has just liquidated. She might still have employer-provided health insurance, but the company may have just jacked up the employee contribution. She knows that if she loses her job, she would have to start spending several thousand dollars a year to purchase health insurance. Meanwhile, this worker—say she's in her mid-40s—is providing for her own retirement via a 401(k), whose balance has fallen by 40 percent in the last year. Oh, and her adjustable-rate mortgage is about to readjust to a higher rate.

So, what happens if you cut this worker's payroll taxes (assuming she's on somebody's payroll and isn't a contractor or self-employed)? Well, she might spend the increased cash flow. But given everything that's going on, a fearful but still rational person might not rush out to spend or invest the money. She might be far more likely—and well-advised—to save it, to build up a cash hoard that would allow her to remain solvent should she lose her job, or to prepare for the eventuality that she might have to buy her own health insurance. Or she might start shoveling that extra $100 per week into her 401(k) to make up for some of the huge losses she's suffered.

Psychology plays a big role in all sorts of economic decisions. And at times like these, when people are gripped with fear, it plays an even larger role. In such a climate, cutting taxes can't hurt. But should we expect it to have the same effect it would have in a period when people are generally confident and secure? If you believe the typical American worker would respond to tax cuts the way a typical tenured Harvard economist would, then it makes all the sense in the world to focus on tax cuts to the exclusion of other types of stimulus. But if you believe the typical American worker might respond to tax cuts the way, say, a typical Cambridge-area worker would, you might be less sure.