In Praise of Tax Cuts!

With Congress half-way through a new stimulus bill that would extend aid to the jobless and renew tax cuts for small businesses, it's worth thinking about what tax cuts are supposed to accomplish in a recession.

The good thing about tax cuts is that they are timely and targeted. You can send check to families faster than you can set up federal projects. The bad thing about tax cuts is that there's no guarantee that the money is actually spent to stimulate the economy. Families might just sit on the cash, and the impact on overall demand is negligible.

Tax cuts might have been especially well-suited to this downturn, Mark Thoma writes, because we've suffered through what he calls a balance sheet recession. The collapse of the Dow and real estate markets blew a hole through families' personal accounts and retirement plans. As a result, many families looking to pad their savings pocketed the tax cuts in the stimulus. That's bad for stimulating demand in the short term. But it's good for re-building balance sheets to get future consumption on stable footing.

Saving money might make sense for individual families. On a macro level, a nation of thrift savers is a nation plummeting into a deflationary cycle. Families cut back on gizmo purchases. Gizmo shop owners stop ordering gizmos from the factory. Gizmo factory workers get the pick slip, cut back on spending, buy fewer gizmos, hurt more gizmo shop owners, and get more gizmo workers fired. That's where you need the federal government to supplement tax cuts with outright spending to keep public workers employed, create infrastructure projects and dangle incentives for businesses to invest and hire.

The politics of the Recovery Act (which broke down about 40/60 on tax cuts and spending) have been fraught. Conservatives wanted a tax-heavy solution and hated the result. Liberals wanted a higher-spending solution and have blasted the White House's parsimony.  Meanwhile, 50 percent of Americans think the Recovery Act failed because unemployment still clings to double digits. Still, Thoma's interpretation, which I'm still thinking through (I'm not convinced that American saving rates truly recalibrated), is an interesting bit of Goldilocksism. Even if the Making Work Pay tax cuts didn't power a spending boom, they may have paved the longer road to economic recovery by addressing America's balance sheet recession.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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