## Sunday, February 1, 2009

### Who's going to spend the money?

As I've written before, one of the big debates in the stimulus is whether tax cuts or government spending are more effective for boosting short-term demand. Paul Krugman weighs in:
"...one way to explain why government spending is better than tax cuts as a stimulus is to say that temporary tax cuts aren’t effective at increasing demand, but temporary spending increases are.

Here’s the logic (which follows directly from Milton Friedman’s permanent income hypothesis, by the way): suppose that the government introduces a new program that will cause it to spend $100 billion a year every year from now on. To pay for this, it will have to raise taxes by$100 billion a year, permanently — and if consumers take this into account, they might well cut their spending enough to offset the increase in government purchases.

But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say,$5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)

So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts."
According to Friedman's "Permanent Income Hypothesis" spending decisions are not based on transitory income gains (windfalls, such as tax rebates), but by a person's real wealth. This is why tax rebates tend to get put in the bank, rather than spent.

Tax rebates were ineffective as fiscal stimulus in 2007 for exactly the reasons Friedman's theory would have predicted. Of course Friedman would not have been in favor of large government spending, either. But it's interesting to consider the full implications of a theory.