Stimulie, I

by Russ Roberts on January 22, 2008

in The Economy

After my commentary on NPR, I spent a lot of time last week talking to bright non-economists about the various proposals to stimulate the economy by giving people money. Most of them presumed that of course giving people money will improve the economy. I realized that most people have trouble with what might be called "macro intuition." So I thought I would start a series of brief observations on why giving people money is unlikely to cause the economy to grow.

Let us begin with the most basic question. If you received a windfall, that is, an unexpected increase in your income, what would you do with it? The right answer is that it depends. If it is a one-time increase, you would respond differently than you would if it were a permanent increase. A one-time increase is more likely to be saved compared to a permanent increase. With a one-time increase, you might use it to pay off current debt. Or you might add it to your savings. Or you might spend some of it and save the rest. Or you might spend all of it.

Would the answer depend on where the money comes from? It would seem to be irrelevant, but it’s not. If you are the only person receiving the money, say from an unexpected inheritance, you might respond differently than you would if you knew that everyone was getting a tax reduction.

Let’s consider two different situations.

1. Your rich uncle dies who hated you. But he left you money anyway—$1600. What do you do with the money?

2. The government announces a $1600 rebate for all families, financed by borrowing. What do you do with the money?

With the inheritance, you feel a little richer. You might splurge on a fancy weekend in New York. Or you might save all of it. Or something in between. But with the rebate, you are less likely to spend it. Why? Because your taxes (or someone’s taxes) are going to go up in the future and that will discourage the feeling that you’re wealthier. It’s not just a feeling. We as a society aren’t any wealthier. To see the importance of this effect, imagine that the government announces that there will be no taxes collected this year. Concerned about a recession, the government is collecting no taxes in order to encourage consumer spending.

Consider a family that because of the magnitude of this tax cut, finds they have an extra $16,000 available rather than a mere $1600. Imagine the husband calling his wife. "Honey, great news. The government isn’t going to collect any taxes this year. We have an extra $16,000 to spend. Now we can finally (choose one: take that cruise, replace the minivan, renovate the bathroom)."

The wife replies "Well, if the government isn’t going to cut spending (and they’re not, because that would offset the stimulus of the tax cut, wouldn’t it?), then it’s going to have to borrow all the money to cover its spending for this year. The bonds the government sells are going to have to be repaid. We’re going to have higher taxes next year and the year after. I think we better put that $16,000 aside to pay for those taxes."

Who wins that argument?

The wife, don’t you think. So if a $16,000 tax rebate isn’t going to stimulate spending, why would a $1600 rebate? Because people won’t realize that they’re going to have higher taxes in the future?

And as will see in future posts, even if it is different, it still isn’t clear that it will stimulate the economy.


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