Temporary Vs. Permanent Tax Cuts and Marginal Propensity to Consume
Economists have long argued over whether tax cuts stimulate the economy efficiently and, if they do, which kind of tax cut stimulates consumption best. Ironically, the debate begins with the proposal of the "absolute income hypothesis" by John Meynard Keynes, one of the world's best known liberal economists, and continues with the proposal of a "permanent income hypothesis" by Milton Friedman, America's best-known conservative economist.
Absolute Income Hypothesis
Keynes proposes an absolute income hypothesis: how much a household spends depends on its absolute income level. By "absolute income," Keynes means income without respect to what others earn. "Relative income," on the other hand, is the income that a particular household earns relative to other households. Keynes states that as absolute income rises, consumption rises, but not necessarily to the same extent -- there is only a "marginal propensity to consume," with the remainder of additional income going to savings. While Keynes' hypothesis is generally accepted, it is also viewed critically. Some criticisms relate to the observed difference between consumer responses to temporary and permanent tax cuts.
Permanent Income Hypothesis
Friedman proposes a "permanent income hypothesis," in which households consume not in response to current income, but in response to their expectation of longer-term income. Research confirms that a temporary tax cut has under a third of the stimulative effect of a permanent tax cut. A household's propensity to consume depends upon a confidence in long-term financial prospects, which, in many circumstances, a temporary tax cut does little to improve.
Tax Cuts in the Political Sphere
While acknowledging that tax cuts leave more money in the hands of consumers, liberals note the marginal propensity of tax cuts to stimulate consumption -- only a portion of every tax-cut dollar is consumed. Even then, the stimulative efficiency of a tax cut depends upon whose taxes are cut. Friedman notes, for instance, that low income households consume proportionally more of their income than high income households. High income households may treat the additional money in ways that do not directly stimulate the economy -- by investing it in the stock market, for example. Conservatives respond that investments have long-term benefits that eventually prove highly stimulative.
Complications in Applying Theories
A number of related issues complicate the tax cut debate. A summary of research in the 2010 "Annual Review of Economics" shows that the stimulative effects of additional income aren't linear with respect to income increases. Smaller tax cuts may have no stimulative effect. Credit policy has a greater influence on marginal propensity to consume than earlier economic theorizing took into account. The 2008 credit crunch that began in the housing market is a notable instance of how credit policy reduces consumer confidence, hence consumer spending, even among those not immediately affected -- renters, for example. Other research notes the importance of relative income in determining feelings of economic well-being: it's not only how much you make, it's how your income compares with the income of others.
- Congressional Research Service: Tax Cuts and Economic Stimulus: How Effective Are the Alternatives, pp. 2-3
- The Annual Review of Economics: The Consumption Response to Income Changes
- Cornell Conference on Relativity, Inequality and Public Policy: Relatively, Inequality and Optmal Non-Linear Income Taxation, pp. 18-19
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