A Stimulating Debate That Just Might Boil Down To Perception
Regardless of where you stand on the debate, one thing is for certain - no one really knows how the current tax break incentives will play out in terms of stimulating the economy. When I first learned about the Obama’s new stimulus package, thanks to the insightful reporting of our Wisebread writers, what made the biggest impression on me (maybe because it was the only thing I could understand), was the payroll tax rebate.
Under Obama’s plan, the American Recovery and Reinvestment Plan of 2009, the most tangible aspect for a working class stiff like myself was the tax break of $400 per individual ($800 for married couples filing jointly). That money, however, would be delivered via lowering payroll deductions over the course of a year.
In other words, the average consumer will be making about an additional $13.00 per week. My first reaction to this, echoing sentiments of some of my Wisebread colleagues, was a little skeptical. What, I thought, was I going to do with $13.00, and how the heck was that going to impact the economy? Wouldn’t it be more effective, as with the previous administration, to give it to us as a lump sum, so we could go out and blow it on a massive shopping spree?
Furthermore, according to a recent AP poll, most people intend to either save the money or use it to pay off debts, thus negating the goal of the rebate in the first place. So what exactly was the President thinking?
Well, like a lot of things in life, particularly economics, it seems to depend on who you talk to.
According to the Nobel prize winning economist Milton Friedman, of the Chicago School of Economics, who developed the theory of permanent income, our spending is dictated by the long term expectations of what our wealth will be over the course of our lives. Along these lines, short term changes in income (like tax rebates) should not have an effect and will not work towards stimulating the economy. For the record, Friedman was an devout free market capitalist and favored the complete abolishment of taxes while moving towards a laissez-faire economy in it’s purest form.
On the other hand, behavioral economists look at things a little differently. They try to explain the aberrant behavior of markets (the ones that don’t conform to economic models and predictions) by including emotions, as well as psychology, into the equation. In many ways it is a radical shift in thinking because, unlike classical economics, it assumes that people are not always rational in their decisions and don’t necessarily follow the logical patterns of behavior that are necessary for classical economic models to hold true.
Take, for example, credit cards. In purely economic terms, it really makes no sense to go into debt at 19% interest, while your savings are probably paying you a paltry 2% to 4%. The better idea is to pay with cash, or do without. But that’s just the tip of the iceberg. When you really get down to it, our lives are filled with examples of irrational behavior, from the intoxicating effect of sales to the lost time and expense we’re more than willing to sacrifice in order to find a bargain, even if it ends up costing us more.
So maybe there is something to behavioral economics, after all. One aspect of that pertains to the stimulus debate is the concept of mental accounting. Developed by Richard Thaler, also of the Chicago School, it states that when we receive income, we mentally “frame” it before deciding what to do with it. That perception, as well as such considerations as the source of the income and the amount, will then determine whether or not we will save it or spend it.
In other words, according to behavioral economists, our spending decisions are not based on the long term prospects of our wealth, but are instead influenced by our real-time income in the here and now. So the amount of our take-home pay will have a greater influence on our spending than the value of say, our assets.
In fact, as described in the Journal of Economic Psychology, refunds delivered in monthly installments (as is the case for a payroll tax rebate) would encourage spending more than a lump sum increase, which was found to increase savings, instead.
For some of us, it might actually strike a chord. After all, small increments in income might not be worth saving, much in the same way that small increments in price might not discourage us from upgrading our purchases. What’s a few more dollars? Then again, spread out over the entire country, it could mean a lot.
In the end, nobody can say what the end result will be, but one thing is for certain - the plan is in place, and that’s not going to change anytime soon. So for all of our screaming about the economy and whether Obama’s stimulus plan has merit or is complete foolishness, maybe the better question to ask is what exactly are we going to do about it?