Krugman: Tax Cuts And The Economy

[ProSense]

Tax Cuts And The Economy

If we could wave away political reality, I’d let all the Bush tax cuts expire, and use the improvement in the budget outlook to justify a large, temporary increase in public spending. Unfortunately, that’s not going to happen. Given the political realities, I’d go for a temporary extension of the lower-end cuts, and just letting the upper-end cuts expire.

Why?

It comes down to the dual fiscal problem the U.S. economy faces: short-term, the government needs to do all it can to prop up spending; long-term, it needs to reduce the deficit. The latter concern means that it would be a terrible idea to make the high-end tax cuts permanent; that would be a huge drain on the public finances, serving no good purpose. But why not a temporary extension? Because it would do very little to promote spending.

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Isn’t the same true for lower-income people? Not to the same extent. Permanent-income reasoning doesn’t fully apply when some people are “liquidity-constrained” — they have depressed income, which would make them want to spend more than they earn right now, but they’re out of assets and unable to borrow, or unable to borrow except at relatively high interest rates. People in that situation will spend much or all of any temporary windfall.

So if we give money to people likely to be liquidity-constrained, they are likely to spend it. That’s why aid to the unemployed is an effective stimulus; it also suggests that tax cuts for lower-income workers will be relatively effective at raising demand. But the affluent, who typically have lots of assets and good access to borrowing, are much less likely to be in that situation. So tax cuts for the lower 60 or 80 percent of the population are an OK, not great but OK, form of stimulus; tax cuts for the top 2 percent, not at all.

So: let the high-end Bush tax cuts go.