Home > Fiscal Policy > Temporary Tax Cuts: Much Ado About Nothing

Temporary Tax Cuts: Much Ado About Nothing

The current impasse in Congress regarding the extension of two percent payroll tax cuts has dominated economic news reports in the last few days. There appears to be a difference of opinion between members of the Senate and the House of Representatives over the length of time that these temporary tax cuts will be in effect: two months in the Senate version of the bill, twelve months in the House version of the bill.

The purpose of this essay is to argue that economic theory implies that temporary tax cuts over either time horizon will have a negligible impact upon economic activity.  The theory that reveals the effects of temporary tax cuts is the Permanent Income Hypothesis of the late Milton Friedman, developed in the 1950s.

Friedman’s theory breaks up income and consumption into permanent and transitory components. Transitory income is usually thought to be a windfall of a sort or perhaps unexpected overtime work by a manufacturing worker. The crucial point is that it is only a temporary change in disposable income. Permanent Income is the predictable disposable income expected to be earned by a household over a substantial number of periods in the future. Permanent consumption in this theory is proportional to Permanent Income. Total consumption, what we can measure in the government’s economic statistics, is the sum of transitory and permanent consumption.

It is easy to show that a tax rebate has a negligible impact upon permanent income. So we might expect that a tax rebate would stimulate a substantial amount of transitory consumption which is clearly the expectation of the politicians who support these tax rebates. Did the tax rebate stimulate transitory consumption? Empirical evidence is needed to answer this question.

Empirical Evidence

To test the implications of this theory of household consumption, a natural experiment is the tax rebate advocated by the Bush Administration which gave tax rebate checks to households in 2008. The rebates clearly were transitory income since they were a one-shot deal and so we might ask how consumption responded to the receipt by households of this tax rebate. The graph below provides the evidence.

On the chart. we plot monthly constant-dollar real consumption and disposable income for 2008. The data were taken from the St. Louis Federal Reserve Bank FRED database. The effect of the tax rebates on disposable income is clearly evident because there is a spike in disposable income. But notice the response of consumption; it is negligible at best (click on the chart to enlarge it for clarity). So the data suggests that consumption, the sum of transitory and permanent consumption, responded by only a trivial amount.  Such a tiny increase in consumption cannot possibly have a large impact on U.S. GDP.

Thus we conclude from our empirical evidence that a temporary tax cut will not make a  large difference to household spending and we can make a similar argument regarding temporary tax cuts and the decisions made by firms regarding employment and other magnitudes. The reason stems simply from the fact that households and firms make their decisions over many periods of time and temporary tax cuts have a trivial impact upon the resources of firms and households when viewed over long stretches of time. So the dispute in Congress is a dispute over nothing of consequence. All of the fuss is much ado about nothing.

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Economics One

A blog by John B. Taylor

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