Wednesday, December 19, 2007

Summers Tax Cut?

The WSJ has an article today with the headline, "Ex-Treasury Secretary Calls for Tax Cut, Spending Plan". After reading Summers speech before The Brookings Institute though I would have to say that the headline is a little misleading.

Fiscal stimulus is critical but could be counterproductive if it is not timely, targeted and temporary. Gene Sperling’s Bloomberg column this week makes these points strongly. To respond to an incipient downturn, fiscal policy has to have its impact in a timely manner. It has to be targeted to assure that increased government borrowing translates directly into increased spending and demand. And, critically, it has to be temporary so that its effects are not offset by higher long-term interest rates. Indeed from the point of view of stimulus, the optimal package is one that raises spending and the deficit in the short run while reducing the deficit in the long run and thereby reducing long term interest rates. Any actual fiscal stimulus program would have to be worked out in the context of events as they unfold and should be walled off from longer term policy considerations where actions to assure long term fiscal sustainability are essential.

It is reasonable to suggest that stimulus approaching $50-$75 billion -- roughly in the range of 1/2 of 1% of GDP -- is likely to be appropriate. The largest part of this stimulus should come in the form of tax cuts distributed equally among all taxpayers and recipients of tax refunds. Other elements of a stimulus package should include extension of unemployment insurance benefits given that long term unemployment is already at recession levels, temporary step-ups in food stamp benefits which can be executed and have effect very quickly, and tax measures to eliminate from taxation the so-called income that homeowners receive when they are foreclosed, a step that has just been passed by Congress.

Temporary tax cuts will not have the fiscal impact that is needed. Every time temporary tax cuts have been tried in the past they have not had the intended impact. Since taxpayers know that the cut is temporary, they tend to save a large portion of it rather than spend it and the stimulus is muted. Likewise, extending unemployment benefits will not be effective at reducing long term unemployment. A corporate tax cut would be much more effective.

Summers proposal is nothing more than a band aid and one that will be unlikely to have much impact on the economy.

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