In Bush’s Economic Stimulus Package, Timing Is KeyPublished: October 10, 2001 in Knowledge@Wharton
Economists don’t agree yet about whether the U.S. economy was in recession before Sept. 11. But just about all of them are sure it’s in a recession now, and they say the ripple effects of the Sept. 11 terrorist attacks are making it worse.
The question is: How do you turn things around?
The Federal Reserve has slashed interest rates to spark spending. President Bush has proposed a $75 billion economic stimulus package that emphasizes earlier implementation of corporate and individual tax cuts scheduled to take effect over the next few years.
Bush and many Republicans believe that reducing taxes will leave companies and citizens with more money to spend, spurring production of goods and services and creating jobs. Bush’s package, which does not yet include detailed breakdowns, would come on top of the approximately $40 million Congress has authorized in emergency spending for disaster relief and a bailout of the airlines.
Democrats say Bush’s focus on tax cuts mainly benefits the affluent and would not pump money into the economy quickly enough. They urge more help for working people, such as extended unemployment benefits, health care coverage and job training. Bush wants only about a third of the $75 billion to go to these programs.
Can government engineer an economic turnaround? And if so, what techniques work best?
The theory behind any stimulus package is to replace the demand that has been lost, says Wharton finance professor Jeremy Siegel. Boosting demand should drive the economy to boost supply – to create more goods and services and restore economic growth and hiring. New government spending is, in effect, an addition to existing demand in the economy. In the same way, tax and interest-rate cuts boost "private" demand by giving businesses and consumers more to spend.
"When you ask, ‘Do they work?’ we don’t know how much demand is going to contract as a result of these terrorists’ attacks," Siegel says. "If demand shrinks by $200 billion, and that’s very likely … then this $75 billion plan will only go part way towards offsetting the lost demand."
Moreover, he says, there is no way to know how much of a tax reduction will convert into spending. "Certainly, part of it will, but not 100%."
Indeed, some economists have argued that individuals tightening their belts against the recession have been banking the recently-mailed tax rebate checks rather than spending them, making it doubtful they would spend any new tax-cut proceeds.
Corporations, some economists say, are not likely to use low interest rates and tax savings to invest in expansion because their chief problem is overcapacity arising from excessive investment in the late 1990s. Hence, they need to spend less, not more.
To some extent, government efforts to guide the economy run afoul of the lessons of the past four decades, says Alan Beckenstein, professor of business administration at the University of Virginia’s Darden Graduate School of Business Administration. "The evidence has pretty well been that stable, consistent policies, rather than ones that attempt to time the business cycle, make a lot more sense," he notes.
"Attempts to time the business cycle were often based on faulty forecasts and lags in implementation, so that by the time a policy got into place it was chasing the wrong phenomenon." Beckenstein says. If there is to be an attempt to influence the economy, monetary policy, such as the Federal Reserve’s interest rate cuts, "is the more adroit weapon." Fiscal policy, such as tax cuts and government spending, tend not to work as well, since these approaches are slow to implement and get tangled in politics.
For any economic stimulus to work, it must take effect quickly, agrees Wharton finance professor Richard Marston. "The idea is, we need immediate relief." Programs that provide money immediately to the less-affluent consumers satisfy this test, he says. An unemployed person, for example, is likely to quickly spend any money received in a tax rebate. It is less certain that a well-to-do person would immediately spend a tax-cut windfall.
Many millions of the least affluent Americans pay no federal income tax. An income tax cut would therefore not provide them with more spending money, according to Marston. But nearly all workers pay Social Security tax, so a temporary cut in this withholding could quickly translate into new spending.
Extending the period during which people can receive unemployment benefits – an approach on which Bush and the Democrats generally agree - would spur spending in the same way, Marston says. But adding on to the standard 26-week benefit period could mean the additional spending by people losing their jobs this fall would not kick in until well into 2002. That might be too late, he adds.
Timing, Marston points out, is also a problem with government-funded rebuilding, since much of that money will not be spent for years. "It’s not something that will stimulate the economy. An awful lot of that money will not be spent during the downturn. It will be spent later." Additional spending that comes after the recovery could have a negative effect, spurring inflation, he says.
Similarly, permanent tax cuts may stimulate spending too late. The ideal approach, according to Marston, would be a temporary tax cut or spending incentive that would have value only over the period in which additional spending is needed. "Clearly, if we’re doing a tax measure what we ought to be doing is talking about something that will cause business to invest more now, and, if they don’t do it now, it goes away," he says, adding that this could be accomplished with a temporary tax credit.
If President Bush prevails with his tax-cut proposals, how much of the cuts would result in new spending?
Wharton finance professor Nicholas S. Souleles has found that 30 to 60% of the money people receive in income tax refunds gets spent over the following three months. "That’s a relatively large effect," he says. In another study, focusing on the income tax cuts of the Reagan years, he found that 60 to 90% of the tax savings were spent. Research done at Princeton shows that people were very likely to spend most of the money that became available after they hit the ceiling on annual Social Security withholdings, Souleles says.
Taxpayers thus appeared more likely to spend the relatively small tax savings they received in regular paychecks. Large refund checks apparently seemed big enough to be worth saving. The three studies suggest that the most economic stimulus would come from permanent cuts in tax withholding rather than one-time refunds, Souleles says.
Clearly, there’s no unanimous view about how a stimulus package should be designed for the current slowdown. But most experts do agree that the stimulus should come sooner rather than later.