It looks like Obama’s new economic plan will include $300 billion in tax cuts to stimulate spending and job creation. How effective can this be? Browsing through a little economic theory might help us find out.
Obama intends to provide tax credits to individuals and families, tax cuts to businesses, job-creation incentives to companies, and money to states, in addition to provisions to increase capital investments. The specifics of his plan include credits of $500 to individuals and $1000 to families making less than $200,000. According to current estimates, roughly 150 million Americans would qualify.
The plan has taken heat from both Democrats and Republicans. Republicans worry about an “open checkbook” approach to spending, while key Democrats accuse Obama of returning to “trickle-down” economics, otherwise known as Reaganomics.
John Kerry spoke out openly against the idea of a $3000 tax credit for each job created, while others doubt that tax credits are an effective way to inject money into the economy when it could be better spent elsewhere. Yet both parties agree that something must be done to stimulate the economy, and want to see an effective bill passed.
We know today that there are two different ways to stimulate the economy: monetary policy (playing with interest rates) and fiscal policy (cutting taxes, providing subsidies, and spending money on social programs). Changes in monetary policy have the most immediate effects, whereas fiscal policy takes much longer to enact and its effects are largely unpredictable.
When interest rates are lowered, the effective price of borrowing goes down. So if an interest rate is lowered from six per cent to three per cent, that’s three cents less the bank has to pay back as interest for every dollar it borrows from the Federal Reserve or the Bank of Canada. Usually this encourages banks to borrow, which causes them to lend more and lower the interest rates that you and I deal with. Interest rates are raised to curb inflation and stop the market from getting out of hand (no one wants the 1920s again).
Currently, banks are terrified: the current financial crisis was caused by the out-of-hand lending practises of the past few years, and banks no longer know how to proceed. So far, the U.S. Government has already attempted to use monetary policy to fix the economy. But even though interest rates are extremely low, banks aren’t willing to lend because they cannot distinguish reasonable risks from poor ones. Thus, government is forced to enter the mysterious realm of fiscal policy.
Why are the effects of fiscal policy so hard to predict? For one, fiscal policy is split into two schools of thought: people tend to subscribe to either “Reaganomics” or “Keynesian Economics.” Tax cuts are usually associated with right-wing thought. President Reagan was famous for his belief that with lowered taxes, money would go to business first and then “trickle down” to the poorest individuals. Companies would be encouraged to hire more workers and raise their salaries.
Left wingers, on the other hand, often subscribe to the theories of John Maynard Keynes—the famous economist who convinced Franklin Delano Roosevelt that the best way to stimulate the economy was not through tax cuts alone, but with government spending. This means providing funding for roads, public works, and infrastructure, because doing so creates jobs. Rather than just hand people money, Keynes Theory ensures that people work for it—the economy is stimulated in a way that promotes public good.
The downside of both types of fiscal policy is an increased budget deficit, which could carry many dangers, including inhibiting productive spending by future governments. Furthermore, no one is quite sure how long the money will take to circulate through the economy. First the tax credits or government project funds go out, and then people spend.
Say you are given a dollar. You spend it on a coffee, the coffee shop owner spends the profit s/he made on your dollar, and so on. The effect of this dollar would not be limited to its value; instead, it would be multiplied. Economists call this “the velocity of money,” and refer to the multiplying powers on that dollar as the multiplier. The multiplier is shrunk by tax rates and an increased desire to save money. We can estimate these effects, but in the real world, it is nearly impossible to know for sure.
Another mystery in fiscal policy is the business cycle. Economists believe that the economy operates in cycles: booms usually occur at the top, and recessions at the bottom. The problem is that there is no way of knowing where in this cycle we are, or where in the cycle we will be when fiscal policy changes take effect. Theoretically, the policy enacted today could come into full effect six months after the economy repairs itself, leading to inflation that the government would then have to remedy.
Why use fiscal policy at all? It can and does improve things, but there is always debate about how and why—it is a last resort, and a powerful one. Any market is highly dependent on consumer confidence. If people sense improvements, they’ll be willing to spend more.
With blanket tax cuts, you can expect arguments from the Democrats. With promises of social programs, you can expect the Republicans to chime in as well. The change we’re seeing is an attempt at accommodating both sides of the political aisle, but don’t expect Obama-style “change” with regard to the field of economics. Will his plan work? If I could tell you that, I’d probably be appearing on CNN for a considerable sum instead of writing unpaid articles for The Varsity.
