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The Shape of Fiscal Stimulus: Spending vs. Tax Cuts

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The Shape of Fiscal Stimulus: Spending vs. Tax Cuts

by Christian Weller

While the need for a fiscal stimulus has been widely accepted, its exact form remains a subject for debate. For a fiscal stimulus to increase growth quickly, it needs to focus on spending increases and temporary tax rebates for low- and moderate-income families, who are likely to spend the money rather than save it. In contrast, two proposals that are unlikely to accomplish much in terms of economic growth are lower corporate tax rates and cuts in capital gains taxes.

The argument put forth in favor of corporate tax cuts is that they will lower the cost of capital and thus provide an incentive to invest. Several factors, such as interest and dividend payments, capital depreciation, and corporate tax rates, determine the cost of capital. Theoretically, businesses respond to lower costs of capital by increasing their investment outlays. However, beginning with the work of noted economist Dale Jorgenson in the 1960s, economists have consistently found that the cost of capital plays a small role in determining investment-the much bigger player is sales growth. Without the prospects for increased growth of sales domestically and abroad, businesses have no reason to undertake risky investments, regardless of the cost of doing business. The same argument applies to temporary investment tax credits and similar measures designed to lower the cost of capital. The relative ineffectiveness of the Fed’s latest interest rate cuts in increasing investment underscores this point.

Proponents of lower capital gains taxes have even less economic evidence to back up claims of a stimulative effect. They assert that lower capital gains taxes will induce people to invest in riskier assets, such as corporate shares, thus lowering the cost of capital and making it easier for companies to obtain financing. The same argument against lower corporate taxes also applies here, but there is a much more serious problem with this approach: the stock market is not now a source of investment financing. During the recent investment boom, the stock market was actually a drain on – not a source for – corporate resources, as companies repurchased their own stocks and paid out dividends at record rates. In every single quarter between 1994 and 2000, there was a net outflow of corporate capital from the stock market, not the other way around. When the stock market is not a source of investment financing, incentives to invest more money there will fail to create more business investment.

Corporate tax cuts and reductions in capital gains taxes will likely improve the bottom line for companies and boost the wealth of stock holders, but they will do little to stimulate the economy. Businesses are unlikely to spend the money they will receive from lower taxes; rather, they are likely to save it, particularly so they can reduce their record level of debt. Stock holders are just as unlikely to spend all of their additional income from capital gains tax cuts, thereby reducing the effectiveness of this tax cut in enhancing demand. Both tax cuts are likely to increase corporate and private savings, which means less spending – exactly the opposite of what the economy needs right now.

Christian Weller is an economist at the Economic Policy Institute.


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