"A Smarter Stimulus"

I read a really interesting article in the New Yorker last night about President Obama's (!) plan to reduce withholding payments as a form of economic stimulus...

The Financial Page
A Smarter Stimulus
by James Surowiecki

Cutting taxes is usually a surefire political winner. Yet Barack Obama’s plan to include more than a hundred billion dollars in individual tax rebates in his stimulus package has earned him criticism from both ends of the political spectrum. Critics in his own party think the rebate, which Obama wants to distribute by reducing people’s withholding payments, will be too small to make a difference—the equivalent of an extra forty dollars or so a month. Naysayers from the right maintain that, because the tax rebate is a onetime event rather than a permanent reduction in tax rates, it will have only a negligible effect. Skeptics on both sides worry that most people will save the rebate rather than spend it.

One explanation for why rebates don’t have a bigger impact is that they don’t affect what Milton Friedman called people’s “permanent income.” Friedman argued that people’s spending is determined by what they think their income will be over time: they change their spending habits only if they think they’re going to be permanently wealthier or poorer.

If they think of it as wealth, they’re more likely to save it, and if they think of it as income they’re more likely to spend it. That’s because many people tend to base their spending not on their long-term earning potential or on their assets but on what they think of as their current income, an amount best defined by what’s in their regular paycheck. When that number goes up, so does people’s spending. In Thaler’s words, “People tend to consume from income and leave perceived ‘wealth’ alone.”

So what does this mean for making a rebate work? If you want people to spend the money, you don’t want to give them one big check, because that makes it more likely that they’ll think of it as an increase in their wealth and save it. Instead, you want to give them small amounts over time. And you want the rebate to show up as an increase in people’s take-home pay, because an increase in steady income is more likely to translate into an increase in spending. What can accomplish both of these goals? Reducing people’s withholding payments.