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With stimulus, there's more bang in each buck

Tax cuts are less likely than direct government outlays to quickly spur demand, many economists say.

January 17, 2009|Maura Reynolds

WASHINGTON — The $825-billion stimulus proposal that Democrats unveiled this week may encounter stiff opposition from conservatives on Capitol Hill. But it isn't meeting significant resistance from conservative economists.

Though economists might quibble with specifics or express concerns about longer-term effects, the vast majority agree that some kind of massive government spending plan is necessary.

"Most conservative economists are all for it," said Mark Zandi, a founder of Moody's who advised GOP presidential candidate Sen. John McCain of Arizona.

The reason is fairly straightforward. A recession is a prolonged drop in demand for goods and services. Both consumers and businesses have cut back hard on spending. With economic insecurity higher than at any time since the Great Depression, consumers and businesses are more reluctant to resume spending than in previous downturns.

Reluctance to spend can set off a vicious economic cycle, with dropping demand leading to layoffs, further stifling demand. Many economists believe such a cycle may already be underway.

Conventional economic theory holds that the only institution that can halt that cycle is the federal government, which does so by substituting its demand for goods and services for the diminished appetite of the private sector.

Even Martin Feldstein, a professor of economics at Harvard University who served as chief economic advisor to President Reagan and is considered the dean of the country's conservative economists, has expressed support for a stimulus plan.

"Countering a deep economic recession requires an increase in government spending to offset the sharp decline in consumer outlays and business investment that is now underway," Feldstein wrote in the Wall Street Journal last month. "Without that rise in government spending, the economic downturn would be deeper and longer."

Republican lawmakers are often uncomfortable with government spending programs, usually preferring tax cuts. House Republican leader John A. Boehner of Ohio said Thursday that the Democrats' plan "appears grounded in the flawed notion that we can simply borrow and spend our way back to prosperity."

But so far, Republicans have not demanded new tax cuts. For one thing, although permanent tax cuts can foster long-term growth, in the short term most economists agree they create less economic demand -- that is, they are less "stimulative" -- than direct government spending.

Economists explain the spending-versus-tax-cut debate this way: When the government spends $1 to buy an item or a service, economic output (or gross domestic product) goes up by $1. Then it goes up a bit more because whoever gets that $1 spends at least part of it buying supplies or paying workers, who in turn use it for food, gas or medical care. So $1 of direct government spending becomes roughly $1.57 of GDP, according to projections by economic advisors to President-elect Barack Obama.

Tax cuts work differently. If a person gets a tax cut of $1, there is no guarantee he or she will spend it, so it has no immediate effect on GDP. And the worse the economy and the greater the fear of bad times ahead, the more likely they are to hold on to that dollar.

Obama's advisors assume that the $275 billion in tax cuts in the stimulus proposal would have no effect on GDP for the first quarter after the plan is passed. After that, they expect taxpayers and businesses would begin to spend the money they save from taxes. Their models suggest that a $1 tax cut would eventually produce 99 cents worth of demand within two years.

Analyses of how last year's tax rebate checks were spent have convinced economists that taxpayers and businesses are not in a "stimulative" mood. Joel Prakken, chairman of Macroeconomic Advisers, a St. Louis-based economic forecasting firm, estimates that taxpayers spent only 30% of the rebate checks they received.

That meant $100 billion in tax reductions bought just $30 billion in demand for goods and services.

"What happened was exactly what economic theory says should happen," said Valerie Ramey, an economist at UC San Diego. "People knew the tax rebate was temporary, so it didn't make sense for them to go out and splurge. Rebates are not the best way to stimulate spending."

But tax cuts for businesses can be useful in creating the conditions for capital spending and job creation once an economic recovery begins. And a tax cut that ordinary taxpayers perceive as permanent can lead them to increase their consumption once a crisis passes.

That's one reason Obama has tried to send the message that the $500-per-worker ($1,000 per couple) tax cut that is part of the stimulus package will be followed by a permanent change in the tax structure.

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