Wednesday, March 11, 2009

Appropriate fiscal stimulus, and Ricardian equivalence

My colleague, Professor Sinclair Davidson, is now posting at catallaxyfiles. He draws attention to a summary of a new paper by Matthew Shapiro and Joel Slemrod in the latest NBER digest.
In Did the 2008 Tax Rebates Stimulate Spending? (NBER Working Paper 14753), Matthew Shapiro and Joel Slemrod analyze evidence from a rider on the University of Michigan Survey Research Center’s Monthly Survey, also known as the Survey of Consumers, which was included each month from February through June 2008. The rider asked: “Thinking about your (family’s) financial situation this year, will the tax rebate lead you mostly to increase spending, mostly to increase saving, or mostly to pay off debt?” Only one-fifth of the survey respondents said that the 2008 tax rebates would lead them to mostly increase spending. Most respondents said they would either mostly save the rebate or mostly use it to pay off debt. The most common plan for the rebate was debt repayment.

These responses imply that the aggregate marginal propensity to spend from the rebate was about one third and that there would not be substantially more spending as a lagged effect of the rebate. Because of the low spending propensity, the rebates in 2008 provided low “bang for the buck” as economic stimulus, Shapiro and Slemrod conclude. Low- income individuals were particularly likely to use the rebate to pay off debt. Shapiro and Slemrod speculate that adverse shocks to housing and other wealth may have focused consumers on rebuilding their balance sheets. The authors note that, given the further decline of wealth since the 2008 rebates were implemented, the impetus to save a windfall might have become even stronger since their survey was conducted.

The overall results, that the rebate provided a very limited stimulus to aggregate demand, are similar to those found in Shapiro and Slemrod's study of the 2001 US federal income tax rebates. This earlier study is interesting for a number of reasons.

1. They found, somewhat counterintuatively, that individuals who were most likely to be liquiditiy constrained (i.e. lower income) were more likely to mostly save, rather than mostly spend, the rebate.
2. They found that the propensity to spend the tax cut was not associated with expectations of lower government spending. As a result, Barro/Ricardian equivalence, whereby a temporary reduction in taxation will not lead to an increase in aggregate demand (as Ricardian consumers will save more now to compensate for the higher taxes or lower government spending they expect to face in the future), was not supported.

In the Australian context, these two points reinforce the importance of direct government spending in stimulatating economic activity. Of course, even if Barro/Ricardian equivalence holds with regards to an increase in government spending, such an increase in spending can still be expected to generate an immediate increase in aggregate demand. This is because if there is a given increase in government spending of $X this year, consumers will not need to internalise the entire present value of the future tax liability this year. As a result the immediate offsetting reduction in consumption will be less than $X, ensuring an immediate, positive impact on aggregate demand from the increased government spending.

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