Tax Breaks or Government Direct Spending, Is There a Right Answer?
The Times and the WSJ (as well as almost everyone else) covered many of the details of Obama's new tax cut proposal which is part of his overall economic stimulus package. Although this is a common tool used by many presidents during a recession (it was practically George W. Bush's mantra) I think we are facing very different circumstances in the 2008 recession. The articles (NY Times, WSJ) discuss the tax break as a foregone decision, entirely dedicating the focus on the size of the break. The plan is a $300 billion tax cut for those who are currently working, no income cap (the $250,000 that we heard so much about during the debates) has been determined yet. I will ignore my fear of labeling myself an extreme liberal and explain why a tax break may not work, but will also briefly look at why it really doesn't need to work to be effective.
Regardless of actual effectiveness a tax break is a common political response to any recession. The hope is to energize spending with a wealth effect, which jump starts personal consumption. But, in contrast to recessions of our recent past, I do not believe the wealth effect will occur in our current crisis. The difference in 2008/2009 is primarily a change in consumption, stemming from job market instability. I predict this fundamental shift in consumer behavior will prevent a tax break mechanism from making any improvements in the recovery process.
First examine the graph below from the WSJ, (source: "Hard Hit Families Finally Start Saving, Aggrivating Nation's Economic Woes"). The take away is that Americans are not spending... anything. For the first time in a very long time Americans are actually saving money!
As I discussed in previous articles, the Federal Government has a very advantageous cost to capital. With historically low rates on treasuries the government is in a great position to spend, but there should still be some thought to spending wisely. Cutting taxes is not going to give the economy the jolt it needs but I do have two suggestions which I believe might make a wider impact. First direct government spending, and secondly the support for weak state and local governments.
Obama is a champion of direct infrastructure improvements, I can only hope he does not lose his focus on this productive stimulus option. Direct government spending may remind us of the Great Depression but it may not be a bad idea. I had realization that the tone of financial markets were really dire when the short term treasury rate dipped below 0% in December at the same time the Federal Funds Rate was at 0% (see related article "Money Does Grow On Trees..."). Investors just do not trust private investment right now. The solution to restore confidence is to stabilize consumption, which can only be done with a stable job market. When people know their next paycheck will definitely be there, they will spend today. It is scary to say it, but with private business contracting, and private cost to capital extremely high, the logical solution is for government to employ its citizens directly. It stabilizes the job market and will give a lot of attention to some much needed infrastructure improvements. Sounds like socialism? Call it what you want, it will be effective. People will be employed, consumer confidence will return, Americans will soon start consuming in massive quantities, the consumption will spur private activity, the activity will stem the risk of lending to private companies, and the lending will get the whole economy back on track.
Some attention also needs to be made to state/city government budget deficits, which I have not heard addressed on the national level. Many states are in some serious trouble, with
Shifting the gears of pessimism, I want to briefly look at why a tax break does not necessarily need to work1 to be effective2, maybe there is a much bigger plan. This tax break may be a move by Obama to start restoring the spirit of Americans. Consumer confidence is simply all about confidence in ones government and the stability of their lives. The policy, at least in the short term, for this administration is to use everything at their disposal. Money is cheap, treasuries remain low, and moving the Fed Funds rate hasn't given the effect the Federal Reserve was hoping for. As a result Obama is pulling out all the stops. He is vying for the American spirit, comforting citizens by having them believe he is doing everything possible and thereby restoring their confidence in the free market. I personally think $300 billion is a high price to pay for the spirit of Americans but I suppose it may not be the worst idea as long as the Government doesn't run out of money (or have to start paying a significant interest rate). I have outlined more worthy 3(from an investment perspective) uses for the funds, but can accept that there are less tangible victories than the return on investment. I just hope Obama is not expecting some traction from this plan, because it is unlikely to come.