December 5, 2008
Economic Snapshot — December 5, 2008
Permanent tax cuts work, but temporary fixes don’t
According to some, our federal government’s recent Economic and Fiscal Update was disappointing because it did not contain major measures to stimulate the economy.
However, these comments seem to ignore an important economic reality — temporary measures designed to boost spending, such as tax rebates, don’t work.
This fact was very clearly illustrated earlier this year in the United States. In an attempt to increase consumer spending and give the economy a kick-start, the U.S. Congress approved a one-time, $115-billion tax rebate program.
The initiative was intended to provide individuals and households with a temporary income boost that they would, in turn, pump back into the economy by spending. However, as the chart below illustrates, despite the sharp increase in disposable incomes in May 2008, personal consumption has actually declined steadily since July.
As indicated in a recent Wall Street Journal article by John B. Taylor, a professor of economics at Stanford University, the fact that consumer spending did not increase in response to a temporary tax rebate is completely consistent with the permanent-income theory of Milton Friedman.
This theory indicates that consumers’ purchasing patterns do not respond to temporary changes in incomes. However, their response to what they perceive to be permanent changes in income is much more significant. Consequently, a permanent tax reduction causes a significant increase in spending after a short lag.
In Canada, while the GST cut announced by the government late in 2007 was viewed by many to be inefficient, it was permanent. As a result, consumer spending accelerated in late 2007 and early 2008.
In CanaData’s view, the recently announced 2% value-added tax (VAT) cut in the United Kingdom will not have a significant impact on spending for the same reason that the U.S. tax rebate was ineffective — it is temporary.
Given the deteriorating outlook for Canada, the most effective means of providing both short and longer term stimulus to consumer spending and investment would be permanent cuts to personal income taxes across the board. If designed properly, a personal tax cut would benefit taxpayers at all levels of income.
United States – Disposable Personal Income and Personal Consumption
Data source: U.S. Bureau of Economic Analysis/Chart: Reed Construction Data – CanaData.
