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236 IRET Congressional Advisory 1 (2008)

handle is hein.taxfoundation/iretcgadv0233 and id is 1 raw text is: INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION IRET is a non-profit 501 (c)(3) economic policy research and educational organization devoted to informing the public about policies that will promote growth and efficient operation of the market economy. January 28, 2008 Advisory No. 236 FISCAL STIMULUS OR FISCAL FOLLY? Fear of a possible recession is leading to calls for action to restore growth. But what to do? Unfortunately, the fiscal stimulus package negotiated between the Administration and the House leadership is not the answer. The House tax plan would include a tax rebate (up to $600 for single filers, $1,200 for joint filers) and a child credit ($300 per child) to encourage consumption spending by individuals1, and two expensing provisions to encourage investment by businesses. The revenue estimate is about $150 billion. The history of tax rebates is not encouraging. They have not worked in practice (see the discussion of the Ford and Carter rebates, and the first year of the 2001 Bush tax cut, below). They should not work in theory, because they do nothing to reward additional production. They are merely handouts. The expensing incentive in the stimulus package could induce the manufacture of more capital goods in 2008. However, because it is temporary, it would not increase the desired capital stock over time, and would borrow investment spending from 2009. What does fiscal stimulus mean? Fiscal stimulus is a term from Keynesian economic theory for policies that are designed to increase spending by individuals, businesses or government. The object is to raise aggregate demand if it falls short of the potential output of the economy. Either the government spends more directly to boost aggregate demand, or it cuts taxes to let people keep more of their income to spend to boost aggregate demand. stimulus is measured by increases the budget deficit. The magnitude of the how much it initially Problems with fiscal stimulus Problem one: the government constraint. budget Every tax cut or spending increase has to be paid for, either with other tax increases or by additional federal borrowing. The Treasury does not kite checks. In the mid-1960's, monetarist economist Milton Friedman asked, If the government is spending $500 billion, and cuts taxes to $450 billion, where does the $50 billion tax cut come from, the tooth fairy? Friedman then explained that the government has to issue additional debt to cover the deficit. If it sells the bonds to the public, it is borrowing the tax cut right back, leaving the public with no additional money to spend, and, hence no boost to disposable income or aggregate demand. The process plays musical chairs with the money, and does nothing to boost economic activity. (The same analysis also debunks the idea of a stimulus from higher federal spending, which must be covered by raising taxes or borrowing.) Alternatively, the Federal Reserve might step in to buy the added government debt, which it does by creating new money. That would add to aggregate demand, but the rise would be due to the change in the money supply, i.e., to monetary policy, not to the fiscal stimulus per se. The Fed can add to the money g~*m 6 I 8g~ I

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