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Why Big Tax Cuts Are Essential


Let’s get this straight right away. I’m not a dogmatic supply-sider, who believes that tax cuts are the solution to all economic ills.

But I believe that Obama’s $300 billion tax cut is essential to ‘recapitalize’ the American consumer, just like the banks are being recapitalized.

Think about it this way. This economic crisis consists of three parts:

—Mountains of bad loans, which are weighing down banks and other financial institutions

—Rapid retrenchment by businesses, which is causing them to cut jobs and investment

—Trillions of dollars in excess consumer debt, which is forcing households to cut back on spending.

These three factors together are feeding on each other. Because banks are lending less, it’s harder for businesses and consumers to spend. Because businesses are cutting workers so quickly, loan defaults are rising and it’s harder for consumers to pay back debt. And because consumer debt has risen from 96% of disposable income in 2000 to 130% of disposable income today, Americans are completely maxed out. As a result, any job cuts immediately mean more loan defaults.

All three of these problems need to be addressed in order to keep the economy afloat. First, the purpose of the $700 billion in TARP money was to help ‘recapitalize’ the financial system, through injection of money directly into banks and other financial institutions. That must continue until it’s clear that defaults have peaked, which may not be until 2010.

Second, the rising unemployment rate can be directly addressed by government spending programs which create or preserve jobs. Giving money to hard-pressed state and local governments can avoid unnecessary job cuts in education and health care. Infrastructure programs can add construction jobs. And the variety of energy programs that Obama is proposing can goose up an essential sector.

That leaves the consumer. The conventional economic wisdom these days seems to be that tax cuts or tax credits are bad because people save the money, rather than spending it. For example, an article in today’s New York Times says:

But economists said the tax credit could have drawbacks as an economic stimulus measure, mainly because people usually save part of the money or use it to pay down debt. That makes good sense from an individual’s standpoint but does nothing to increase economic activity.

But this conventional argument misses the whole point. Consumers have a massive hole in their balance sheets these days. Home prices are plunging, incomes are slowing, and many families have huge debts. Americans are staggering.

From this perspective, the main purpose of the tax cuts and tax credits is to help repair consumer balance sheets, just like the TARP is helping repair bank balance sheets. I don’t want consumers to spend the tax cuts—I want them to save the money, as much as possible, and get their debt back to reasonable levels. That’s the only to ensure that consumers will be on solid ground when the recession is finally over.

Edmund Phelps, the Nobel Prize winner, made a similar point at his talk at the recent economics meeting in San Francisco. He said:

Stimulating household consumption is not the best remedy for the fallout of the financial crisis…Weren’t we all saying that households are overconsuming?

So the three prongs of the stimulus package serve distinctly different purposes. The TARP recapitalizes the banks, with $700 billion. The tax cut, at $300 billion, recapitalizes the consumer. And the government spending program—say, $500 billion—provides the missing demand and jobs.

Now, all of these numbers, though huge, are probably just a downpayment. My best guess is that we’ll have to do it at least one more time. But in any event, a tax cut—even if it is saved—is an essential part of any recovery package.


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