Sunday, February 15, 2009

Tax cuts won't do the heavy lifting this time

The GOP believes that tax cuts are the best way to stimulate the economy. Republicans would say that tax cuts are preferable to government spending because the American people know best how to spend their money and that the government has a poor track record for effectively spending tax dollars. But Daniel Gross makes a strong case that the traditional wisdom doesn't apply in this recession.

The whole idea behind tax cuts stimulating the economy is that Americans will spend the newfound discretionary income they have when their taxes are cut. It seems logical that if there are less withholdings, she'll buy that new pair of shoes she's had her eye on with the extra money she finds in her paycheck. Or if his income tax refund is unexpectedly large next year, he'll finally buy that widescreen HD TV that's been tempting him lately. Maybe the simultaneously increasing take-home pay and price of gasoline will convince you to finally buy that hybrid car you've been considering (as long as the desperate Big Three are offering so many incentives nowadays).

It makes sense, right? After all, we Americans love instant gratification and we're certainly not savers. Well, maybe it does not make so much sense this time. There are some factors that make this recession unique.

First of all, there is less job security than ever in today's workplace. There are now fewer career employees than ever and we have the highest rate of unemployment in many years. Worse yet, it's plummeting faster than it has in recent recessions:
Job Losses In Recent Recessions(Click chart above to see in full-size from House Speaker Nancy Pelosi's office)
With the large number of unemployed Americans, there are fewer tax payers to spend the tax cuts. This alone reduces the impact the tax cuts will have on the economy.

Add to that the fact that Americans that are still employed lack confidence that they will stay that way long term. Not knowing how long it would take them to find a replacement job in this tight job market, American's feel that they need a larger safety cushion than usual right now. If they would want to have health insurance should they become unemployed, COBRA would be a substantial additional expense that they don't have while employed. Subsequently, Americans are much more likely to save their tax cuts for a rainier day than they are to spend them. While that's fiscally healthy for the individual, it's not stimulating to the economy.

To further exacerbate matters, the housing market is at the root of this economic downturn. During the housing boom, Americans were spending Bush's tax cuts hand over fist on their homes. They improved their homes to accelerate its appreciation. With home values falling like a rock in this recession, homeowners will not be spending their tax cuts at Home Depot because to do so would just be throwing good money after bad. Many homeowners are seeing their ARMs reset, so they will just spend their tax cuts on their higher mortgage installments (to banks likely to go bankrupt anyway). Renters will not likely spend their tax cuts on buying a home because of the concern that their mortgage would just be underwater a few months later.

Finally, there are Americans' retirement accounts to consider. The shrinking Dow reflects Americans' IRAs and 401(k)s. Losing 45% of their nest egg in less than a year, Baby Boomers are postponing the retirement they planned. Instead, they will just have to plow their tax cuts back into their retirement accounts to make up for their recent losses.

Of course, these factors will not completely eliminate the stimulative effect of tax cuts. Nonetheless, they will certainly significantly diminish the tax cuts' impact on this recession. The economic stimulus bill that just passed congress this weekend was the right recipe for this recession. Although it has some tax cuts, it's more heavily weighted to investments in America's future -- monies that we know will be spent.

No comments: