Taylor: Why Permanent Tax Cuts Are the Best Stimulus

John Taylor is not ready to give up on tax cuts, nor is he ready to adopt traditional Keynesian ideas:

Why Permanent Tax Cuts Are the Best Stimulus, by John B. Taylor, Commentary, NY Times: The incoming Obama administration and congressional Democrats are now considering a second fiscal stimulus package, estimated at more than $500 billion, to follow the Economic Stimulus Act of 2008. As they do, much can be learned by examining the first.

The major part of the first stimulus package was the $115 billion, temporary rebate payment… The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand… What were the results? …[C]onsumption shows no noticeable increase at the time of the rebate [see chart]. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.

These results … correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased…

After years of study and debate,… the permanent-income model led many economists to conclude that discretionary fiscal policy actions, such as temporary rebates, are not a good policy tool. Rather, fiscal policy should focus on the “automatic stabilizers” (the tendency for tax revenues to decline … and transfer payments such as unemployment compensation to increase in a recession), which are built into the tax-and-transfer system, and on more permanent fiscal changes that will positively affect the long-term growth of the economy. …

What … can Congress and the incoming Obama administration do to give the economy a real boost on Jan. 20? Here are a few fairly bipartisan measures worth considering:

First, make a commitment, passed into law, to keep all income-tax rates were they are now, effectively making current tax rates permanent. This would be a significant stimulus to the economy…

Second, enact a worker’s tax credit equal to 6.2% of wages up to $8,000 as Mr. Obama proposed during the campaign — but make it permanent rather than a one-time check.

Third, recognize explicitly that the “automatic stabilizers” are likely to be as large as 2.5% of GDP this fiscal year, that they will help stabilize the economy, and that they should be viewed as part of the overall fiscal package even if they do not require legislation.

Fourth, construct a government spending plan that meets long-term objectives, puts the economy on a path to budget balance, and is expedited to the degree possible without causing waste and inefficiency.

Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market.

I’ll note in passing that the New Keynesian model incorporates expectations of the future, and accounts for complex dynamics as well as any model, so the criticism in the last paragraph is really about policy justified by traditional Keynesian theory, not the more modern version. But more to the point, I don’t think anything he said rules out positive net present value investments in infrastructure. We should make these investments in any case if we want the economy to grow robustly, now just happens to be a good time to have the construction and maintenance work done since people need jobs, inputs to production are relatively cheap, and the political atmosphere is accommodating.

Originally published at the Economist’s View and reproduced here with the author’s permission.