As we all are aware, the last few days have seen increasing turbulence in the stock markets both here and abroad and extraordinary action by the Federal Reserve to lower interest rates to address the credit crunch. As the Democrats and Republicans campaign for office, candidates re releasing their proposals for a suitable economic stimulus. Now the Peter Orszag, Director of the CBO, has provided testimony to the Senate Finance Committee about the kinds of actions that ought to be considered. See his testimony, "Options for Responding to Short-Term Economic Weakness" at this link.
Of course, let us also hope that he is correct in thinking that the current problems are truly "short term" and not indicative of a long and deep economic recession. The testimony starts off with an unsurprising acknowledgment that the economy is slowing and can be expected to remain "sluggish" through 2008. Although some have characterized the US economy as already in recession, Orszag notes that there continues to be disagreement among economists regarding whether the US will or will not actually undergo a recession. Growth, in other words, may continue, but at best at a slow pace. Various indicators are looking worse than they were just a few months ago, however, including unemployment statistics, and this uncertainty about the depth of economic problems makes it more difficult to know whether an economic stimulus is necessary.
The testimony notes that various "automatic stabilizers" help the US economy fight recessions, including food stamps and unemployment compensation. Those expenditures by the federal government add to aggregate demand, creating a positive cycle for the economy that counteracts some of the negative forces. The report notes that actions by the Federal Reserve also help, by increasing liquidity. The Federal Reserve has lowered target rates several times--the latest this morning in a surprise action to counter the perceived problem that stock markets around the world were dropping precipitously in response to continuing concerns about a possible recession in the U.S. economy. Thus, the Federal Reserve dropped the target federal funds rate today (Jan. 22) from 4.25 percent to 3.5 percent, an extrarodinarily large drop at one step that was obviously intended to send a strong signal to markets that liquidity will not be a problem.
If policymakers conclude that these actions won't be sufficient to ward off recession and thus decide to enact some measure of additional fiscal stimulus, it will be important to target it appropriately. Any stimulus should be designed well to take effect quickly (e.g., by affecting aggregate demand)--programs that can only affect demand over the long term simply don't make sense in this context.
"Given the elevated risk of a recession, ... targeted policies in mortgage markets or a well-designed and well-timed discretionary fiscal policy may have larger economic benefits than costs, whereas poorly designed or substantially delayed fiscal policy interventions may do more harm than good. Id.
The kind of stimulus needed is a program that "stimulates aggregate demand" and "engage[s] more of the economy's existing short-term capacity." The idea is to think short-term: some tax law changes that are effective for the short term may actually slow long term growth, and some changes that are good for the long term may be ineffective in providing a short-term stimulus. Households whose income increases from a stimulus tend to consume more and that consumption has a "multiplier effect" stimulating production and consumption. The magnitude of the multiplier depends on how much of th increment to income is actually spent. Timing is important--in the long term, what is needed is business expansion, but in the short term, what is needed is increase in demand. Credit constrained households are likely to spend more of the stimulus, and lower-income households are likely to be the most credit-constrained.
Put that all together, and a stimulus that is targeted to lower-income households is more likely to be effective than one targeted at high-income households. Studies of the 2001 rebate bear out that expectation. Lower income households actually increased spending by more than the rebate amount, whereas middle-income households only increased spending about about 20% of the rebate amount.
Orszag notes that tax cuts for busineses may also stimulate, but are much more likely to do so if they are temporary rather than permanent, since businesses will have an incentive to increase their investments now rather than later--i.e, accelerate their plans for making future investments to the present.
There's of course a cost to stimulus programs, and that means an increased deficit. That may be acceptable for the short term, as temporary programs take effect and push the economy, but can act as a negative drag on the economy if they persist for the long term. "The more temporary a stimulative policy, the more likely that it will not significantly exacerbate the nation’s long-term fiscal imbalance."
The testimony notes that a lump sum rebate will be the quickest way to get the stimulus into households. Linking the size of the rebate to the amount of the household's tax liability would not be very effective, since rebates would be more likely to be fully spent (rather than saved) by lower income households that have lower tax liabilities. EVen better, the report notes, is to make the rebate refundable--i.e., even if the household's tax liability is less than the rebate amount, the household can receive the full rebate. This makes sense: provide a rebate that can be significant to lower-income households.
"A refundable rebate would place money in the hands of a substantial number of households that otherwise would not have been eligible to receive the rebate (or to receive the entire potential rebate). "
The testimony considers a number of other proposals, including across-the-board reductions in income tax rates (not a good idea, since the benefit goes predominantly to higher income households that are less likely to spend the full amount), payroll tax holidays (that would provide an immediate benefit to lower-income workers, but essentially waste a similar benefit provided to employers and might lead to wasteful timing games as employers tried to have more compensation covered by the benefit), and extending the 2001-2003 tax cuts (not a good idea, since "[w]hatever the long-term effects on work incentives and investment, permanently extending EGTRRA or JGTRRA after 2010 is unlikely to provide much demand stimulus to the economy in 2008"). It looks in similar detail at potential business stimulus and government spending.
This is a good presentation and provides useful historical information about the 2001 tax rebate program and other stimulus packages that Congress will need to consider as it plans some measures to counteract the growing danger of economic recession. It seems quite clear that one of the best things to do is to get funds into the hands of lower-income taxpayers, through a lump-sum rebate. I hope Congress makes that kind of proposal a keystone, and restricts the temptation of tinkering with other "investment incentives" which won't do as much because they'd merely get more money into the hands of those who already have it. Congress needs to focus not only on the markets generally, and ways to improve the economy, but on the fact that ordinary Americans--those who don't make those huge annual incomes like the top few percent--are feeling extraordinarily uneasy about their economic prospects. The stimulus package should help to stimulate the economy. Ideally, it should also be aimed at another, more nuanced problem--it should help to reassure ordinary Americans that their lot is not going to simply get worse while those at the very top continue to enjoy whatever economic growth there is.
It is worth noting that Treasury Secretary Henry Paulson made remarks about the needed fiscal stimulus before the U.S. Chamber of Commerce today as well. Those remarks, available at this link, concur in the need for a "robust, broad-based, temporary growth plan that can be swiftly passed and enacted."
The JCT released a menu of options derived from past discussions of stimulus. That document is available at this link.