The $300 Billion Tax Cut: Let's Do It Right

President-elect Obama announced on January 8 that he is planning to use $300 billion of his $700 billion two-year stimulus package for tax cuts—but we should not celebrate too soon. Obama is proposing a series of temporary tax cuts, not permanent cuts that would hasten economic recovery.

For two years only, Obama wants to give a tax cut of $500 a year to individuals and $1,000 a year to families, at a cost of about $145 billion over the two years. Rather than mail out U.S. Treasury checks, as was done last spring in an effort to ward off a recession, he would lower withholding rates so that the tax cut would be spread over the year.

Obama and his advisers evidently believe that a temporary tax cut spread out over 52 weeks would induce more extra spending than one delivered all at once. The problem is that tax cuts that are temporary have limited effects on spending behavior. Milton Friedman won a Nobel Prize for his permanent income hypothesis, which showed that spending decisions are made not by the amount of money in consumers’ pockets, but by their expectations of future income.

Businesses with losses in 2008 or 2009 would also receive temporary tax cuts. They would be allowed to convert those losses to cash by applying them to taxes paid in earlier years. Treasury checks for the losses would give them additional cash for new investments.

As an incentive to spend the money, businesses would be allowed to expense—deduct in full—up to $250,000 of equipment in 2009 and again in 2010, up from the present limit of $125,000 a year.

Firms do tend to respond to temporary incentives, boosting current GDP. But they often do this by advancing investment projects from future years to the present, lowering GDP in the future. If a firm, to take advantage of the extra write-off, invests more this year or next, then some additional projects would be advanced from 2011 and 2012, reducing investment and employment in those years.

Businesses would also be given a one-year tax credit to hire new workers, or prevent layoffs, valued at $3,000 per worker, at a cost of $40 billion. This provision is so murky that it will obviously be abused. A company could fire workers and rehire them to get the credit, or announce plans for layoffs in order to qualify.

The goal of tax systems, in addition to raising revenues that governments need, should be to encourage work and investment, and thereby production of national income. Income effects are critical when it comes to assessing the effects of changes in tax rates on government revenues and the inefficiencies associated with different taxes.

The most effective measure would be a permanent cut in individual tax rates and an increase in business expensing, paid for by a permanent cut in spending when the recession is over. The tax cuts of 2001 through 2003 would have been more effective if spending could have been cut in subsequent years.

Economists such as Professor Jonathan Gruber of MIT have found that households earning more than $100,000—typically containing two middle-class professionals—are highly responsive to changes in tax rates. When tax rates rise, their work declines.

Others, such as Professor William Gentry of Williams College, found that higher marginal tax rates discourage entrepreneurs from starting new businesses, which involves much risk. Additional investment in new ventures creates jobs, encourages innovation, and enables people to reap further benefits from economic creativity. (Click here for Gentry's report.)

An efficient tax system is a vital tool for restarting American growth. Improvements in our tax system can help us outgrow the recession and keep up with the rest of the world. If we’re planning tax cuts of $300 billion, let’s do it right.

This article appeared in Reuters.com on January 8, 2009.