? asked in Social ScienceEconomics · 1 decade ago

Why do tax cuts tend to be less stimulative for the economy than increases in government spending?

well?

Update:

It's a homework question, not my opinion.

Thanks guys.

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  • 1 decade ago
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    Because the money that people save through tax cuts they are not required to spend - which would stimulate the economy if they would spend it rather than save it or pay off debts.

    On the other hand, government money is guaranteed to go towards economic investment, so 100% of that money will theoretically be used to stimulate the economy. Money saved by people through tax cuts is not required to be spent, so there is no guarantee that this money will be reinvested back into the economy.

    Understand? Hope my explanation helps! :)

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  • The answer is related to the permanent income hypothesis and known as Ricardian equivalence. The PIH is the claim that people make their consumption decisions based on their lifetime income, not just their current income. So if their income rise for today, they save only some of the extra money and save the rest to spend in the future. This applies to the tax rebates that government gives to stimulate the economy. Hence, tax cuts do not create a big stimulus in the current consumption.

    The Ricardian equivalence is a stronger proposition that holds under more restrictive assumptions. According to this, a temporary tax cut has indeed no effect on output, consumption etc. Because a tax cut today leads to deficit that is financed with additional debt and must be paid for with additional taxes in the future. Then, the reasoning above applies once again. People expect their income fall in the future because of the expected rise in taxes in the future. Thus, they do not spend the tax rebates today and save all of it for tomorrow. This result is not entirely true in the real world but it has a point.

    BTW it is the temporary tax cuts that does not work. Permanent tax cuts, which imply lower taxes in the future as well, can stimulate the economy both today and tomorrow. However since taxes are necessary to finance government spending, permanent tax cuts are possible if there are also permanent cuts in current or future government spending.

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  • 1 decade ago

    The textbook says this, however current research seems to say otherwise.

    http://www.economics.harvard.edu/faculty/barro/fil...

    http://elsa.berkeley.edu/~cromer/RomerDraft307.pdf

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  • Anonymous
    1 decade ago

    The premise of your question is false.

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  • Anonymous
    1 decade ago

    They aren't.

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