The Magazine

Not All Stimuli Are Created Equal

The best plan is a cut in the payroll tax.

Jan 5, 2009, Vol. 14, No. 16 • By LAWRENCE B. LINDSEY
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The question to ask about any infrastructure project being sold as "stimulus" is why the project hasn't been done already. The most common answer is that the state and local political process didn't find that the benefits met the costs--a sure sign that the project is not likely to pay for itself during the expansion phase of the business cycle. Another test of the genuineness of the stimulus intent is whether the federal political process is willing to let go of its own political interests in an effort to maximize the stimulus effect. For example, will Congress waive the Davis-Bacon requirements that drive up costs and reduce the job creating benefits of infrastructure spending? Will they abandon earmarks?

The final argument made for federal funding of infrastructure spending by states is that it is needed to prevent or offset cuts that states will have to make in a weak economy. This argument essentially concedes the points made above, that such spending is really just a safety net for the public sector. It is at best job preserving, not job creating.

Permanent tax cuts offer a much better option. The incoming chairman of the Council of Economic Advisers, Christina Romer, has estimated that the macroeconomic benefits of tax cuts can be two to three times larger than common estimates of the benefits related to spending increases. The relative advantage of tax cuts over spending is even clearer when the recession is centered on the household balance sheet. Some relatively minor changes, like making the current 15 percent tax rate on dividends and capital gains permanent, would not only help household cash flow, but also put a floor under equity prices much as their introduction did in 2003. This would help protect against further wealth destruction and balance sheet deterioration.

But the centerpiece of any tax cut should be employment taxes: in particular, a permanent halving of the current 12.4 percent Social Security payroll tax on the first $106,800 of wages, split evenly between workers and employers. The direct revenue effect of that would be a bit under $400 billion per year, roughly in line with the present quantitative needs of the economy. It also meets our three tests of effective stimulus.

First, the funds would flow directly to households through higher take-home pay and indirectly through a reduction in the cost of employment. Economic studies conclude that the benefits of a reduction in the employer portion of the payroll tax are ultimately received by employees. But the immediate effect would be an improvement in the cash flow of credit-starved businesses (as well as being a marginal incentive to keep employment up).

Second, the funds would be extremely timely, with the benefits hitting the economy with the first paycheck after the plan was implemented.

Third, by lowering the taxation of labor, the plan would help produce a higher-employment recovery than would otherwise be the case.

Since the tax cut should be permanent to have maximum effect, the biggest challenge would be how to make up for the lost revenue once the macroeconomic need for fiscal stimulus had passed. In the short run, effective fiscal stimulus requires that government revenue drop, thereby enriching the private sector, and with the Treasury making the Social Security trust fund whole by way of intergovernmental bookkeeping. Longer term, however, spending cuts or a new source of revenue would be needed.

Given the agenda of the incoming administration, the best source of such funds would be a greenhouse emissions tax. It would be a much more efficient way of achieving the desired environmental objectives of the administration than any of the regulatory or "cap and trade" ideas now being considered. Such programs have failed in Europe since they are so easily gamed. Unlike regulations or cap and trade, moreover, an emissions tax can be phased in and calibrated as macroeconomic conditions permitted, specifically as the unemployment rate declined.

The country would be getting the stimulus it needed in the short run. In the long run it would enjoy a permanent improvement in its tax system, with higher taxes on things it wants to discourage (pollution and oil imports) and lower taxes on things it wants to encourage, specifically employment. A greener America with higher employment is a lot better than simply being another day older and deeper in debt.

Lawrence B. Lindsey is a former governor of the Federal Reserve. His most recent book is What a President Should Know .  .  . but Most Learn Too Late.