Most economists believe that recessions are caused largely by slackening demand for the goods and services that firms provide, which leads to layoffs, which in turn lead to more slackening demand. If the downward spiral is not stopped, it can do real damage that takes a long time to reverse. But most analysts believe that the process can be mitigated with a short-term infusion of government money into the economy to boost consumption so that the recession never reaches a severe level.
Many analysts say this sort of government spending should not be offset with tax increases that would simply take the money back out of the economy. As we've argued before, it seems doubtful that tax increases on the wealthy would undo the stimulative effect, but so long as any deficit-spending is only temporary, there is little downside to this approach.
The short-term government spending therefore needs to be the type that will result in an immediate boost in consumption. Increasing Food Stamps for needy families or extending unemployment insurance benefits fall into this category, since they go to people who have probably been cutting back on necessities and will immediately spend the new cash (or vouchers).
Many experts have also argued that aid to state governments can be stimulative if it goes towards "shovel ready"/"ready-to-go" projects or simply prevents the states from cutting needed services and laying off staff. Either way, the money would immediately put income in the pockets of people working on the funded projects, or would prevent a decrease in income for the state government workers who will otherwise fall victim to budget cuts.
Tax cuts that benefit the wealthy are not likely to stimulate the economy because wealthier families tend to save and invest more of their income. Tax cuts for investment (like new cuts in income taxes for capital gains) are likewise not very stimulative. They mostly benefit the wealthy, and besides that, investment decisions take a while to plan and might not be made until after a recession has passed.
President-elect Barack Obama has proposed to stimulate the economy partly by quickly providing federal funds for the type of "shovel ready" infrastructure projects that can make the country more productive in the long-run, in addition to boosting consumption in the short-run. Suggested projects include building roads and bridges, modernization of school buildings, expanding broadband internet access and making buildings more energy efficient.
Obama's economic recovery plan does include some tax proposals that he made during the campaign and which received a lukewarm response from Citizens for Tax Justice and many tax analysts. Hopefully the economic recovery plan that Congress passes early next year will focus little, if at all, on tax cuts.
What About Tax Cuts Targeted Towards Low- and Middle-Income Families?
In theory, certain types of tax cuts, like the refundable rebates sent to almost all households below certain income levels this year, can also have a stimulative effect because they are targeted to the income groups most likely to spend any new money they receive.
But the evidence shows that only a very modest, short-term increase in consumption resulted from the rebates. Martin Feldstein (the former top economic adviser to President Reagan) pointed out in an op-ed that the federal government spent $78 billion on the tax rebates but consumption only increased by $12 billion in response, meaning most of the money was saved or used to pay down debt.
Different parties draw vastly different conclusions from this. Feldstein and anti-tax pundits argue that tax cuts are not effective in stimulating the economy unless they are permanent, because people are reluctant to change their their spending in response to a change in income that they know is only temporary.
But this is the sort of logic that simply leads back to making the Bush tax cuts permanent. Considering how the economy has performed after eight years of lower taxes under President Bush, it's incredible that anyone still focuses on permanent tax cuts as a solution. (This is particularly true since calls for permanent tax cuts are often made by lawmakers who have no desire to replace the lost revenue, which means that increased government debt will require future tax increases or cuts in public services.)
The more sensible conclusion from the limited effects of the rebates is that any government spending or tax cuts need to be more focused on the people who are most likely to immediately spend any new cash or vouchers they receive, or focused on the sort of programs or projects that will immediately result in economic activity in the short-run (and if possible, enhance our infrastructure and productivity in the long-run).
Obama has argued that the refundable Making Work Pay tax credit he proposed during his campaign as part of his overall tax plan could be enacted quickly as a stimulative measure. The credit would be up to $500 for working adults ($1,000 for a married couple if both spouses work) which is the equivalent of refunding Social Security taxes on the first $8,100 of earnings. The credit would be limited for households above certain income levels.
It's not immediately obvious that this will be more effective than the rebates sent to households this year. However, if this tax rebate is sufficiently targeted to low- and middle-income people, it will be far more effective than some of the more radical tax cut proposals put forward by conservative lawmakers (as described in the following article).