Some stimulus with that tax cut, sir?

Richard Berner has a nice piece on the Morgan Stanley Global Economic Forum site on the various tax cut/stimulus packages winding their way through the congress. His recommendation: to stimulate job creation, cut payroll taxes on both employees and employers.

It's easy to understand why headline writers latch on to the ten-year price tag; after all, it's the only common metric across the proposals. Comparing the four plans that are now on the table is difficult because they differ significantly in magnitude, timing, and composition. Three of the four plans would accelerate -- retroactive to January 1, 2003 -- individual tax rate cuts currently slated for 2004 and 2006. They would also provide some form of dividend tax relief, and accelerate in varying degrees the already-enacted expansion of the 10% and 15% tax brackets, marriage penalty and alternative minimum tax (AMT) relief, and the child credit to $1,000 per child. The two Senate plans include $20-40 billion in aid to state and local governments, but the one from Senate Democrats consists mainly of short-term wage credits, expanded unemployment insurance, and revenue offsets from curbing tax shelters.

These compositional differences among the plans explain most of the differences in the scale of fiscal stimulus they offer in their first year. For example, the Senate Democrats' plan has the smallest 10-year cost, but its authors claim $125 billion in first-year stimulus. That's because most of its stimulative features are temporary and most of the revenue offsets only kick in later. In contrast, the Senate GOP plan (as it stood at week's end) nets to a 10-year cost more than twice the size of the Democratic proposal. Based on Congressional Joint Tax Committee data, however, we estimate that its first-year stimulus is only about $70 billion, because some of its stimulus comes on more gradually and is permanent.

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Will it work? The devil will be in the details of the ultimate plan, I believe, which will determine its likely effects in the first year or two of enactment. The acceleration of existing tax cuts and other provisions does add significant stimulus -- $32.5 billion in FY03 and $92.9 billion in FY04, according to the Joint Tax Committee. But I believe that acceleration of the rate cuts and other provisions aimed at lower- and middle-income consumers would produce more stimulus per dollar than such measures implemented across the board. In my view, such consumers tend to spend a higher fraction of their discretionary income than do more affluent taxpayers. Composition would also determine the stimulative impact of federal aid to state and local governments. For example, aid to fund homeland security that staved off tax hikes and/or spending cuts could be highly effective. That especially would be the case if the would-be state and local fiscal restraint included sales tax increases and hikes in the fees for local services. Such actions are regressive, falling most heavily on lower-income taxpayers.

Of course, there are broader macro issues that confront appraising the impact of any increase in fiscal stimulus. The tax cuts enacted in 2001 got little economic traction, so why should additional stimulus work now? My answer is that, then, other factors offset the stimulus, and those post-bubble headwinds have since faded. Yet figuring the ultimate impact of any fiscal stimulus plan must recognize its macro side effects. Many are concerned that because of rising debt and deficits, higher real interest rates might "crowd out" the stimulative effect of tax cuts. But I think that the effect of higher budget deficits on real rates likely would be small, on the order of 20 basis points for each percentage point of cumulative increase in deficits relative to GDP (see "Deficits, Interest Rates and the Dollar," Global Economic Forum, December 16, 2002). In addition, the incentive effects of certain tax changes are important in appraising bang for the buck. For example, if job creation is the goal, I think payroll tax cuts are the best way to get there. They put money in the hands of those most likely to spend by reducing a regressive tax on wage income that every worker pays. And they would cut the tax on hiring for employers -- a healthy blend of demand- and supply-side economics.