A Stimulating Debate That Just Might Boil Down To Perception

by Fred Lee on 16 April 2009 8 comments
Photo: ilker

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?
 

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Guest's picture
Rhiannon

Although I would certainly prefer to get my tax break in a lump sum, I actually think that giving us $13/week is a better idea in terms of "stimulating the economy." I can guarantee that if I got a check in the mail for $400, it would either go straight into my savings account or towards paying down my student loans. With a measly $13/week that I'll barely notice, I'm much more likely to spend the money. I imagine all those people who think they're going to save their tax break money will find it much more difficult to do so with this disbursement method.

Julie Rains's picture

This is an excellent post -- I am familiar with the general ideas (spending based on expectations over the course of a lifetime vs. monthly spending) but hadn't really considered that there was such a discipline as behavioral economics. Nice theoretical reflection with discussion of practical implementations of policy.  

Guest's picture
Rosa

Since I base my fun spending on how much is in the spending account, I would totally have spent that extra cash - except I knew about it ahead of time, so instead I upped the amount that goes into the "savings" account.

My paycheck is auto-deposited, part into the joint account we pay our bills into, part into the "savings" account, and whatever's left over into my fun spending account. So if this wasn't all over the news, I would have just looked at the number in the "fun spending" account and thought, hey, we should go out to dinner!

Managing my *own* irrational behavior is a big part of why I follow financial news & blogs like Wise Bread.

Guest's picture
The Economist

Good article. Thanks for the read. I found your writing on the Chicago School to be pretty interesting. I would like to note though, that the Austrian School of Economics is a bit of both the Friedman and 'behavioral' ideas, only more so. In the Austrian School, economics is looked at, not in terms of number, but as a form of human interaction. In that way, it recognizes that there are certain 'laws' that influence those actions. For instance, the law of supply and demand would be considered one such observation.

What I find so interesting about the Austrian School, and it's followers like Ludwig von Mises and Thomas Woods, is that their observations hold true to all people in all times. Like gravity, it can predict outcomes, not in terms of numbers, but in terms of eventual outcomes.

In terms of stimuli for the economy, the question should really be, does the economy need to be stimulated, why and how. What has gotten us to this point in our economy was the overspending that people and businesses made, and their inability to pay back on all of their hedged bets. It was a house of cards that, once it made its way all the way down to the sub-prime real estate market, collapsed. Hedge after hedge fell.

What seems to be sadly seen as the fault of our problems now is that we didn't spend enough! So the solution has been to spend more. Two wrong won't make things right. The reality is that our economy needs to contract. Our economy has been living as if it thought that it's credit cards were actually a source of income. We're now having to figure out how much each of us is worth without having them. And the reality is, we're a lot poorer than we thought.

So back to the article. The thing that this article may be trying to answer, but seems to have missed, is not how people will spend their money, but if spending more money will help anything at all. I believe that answer to be no.

Credit is not capital. Capital is only created through savings, which banks then lend out to people to be turned into productive business. You can't fake it. And right now, we're being faked. Faked into believing that we can spend our way out of this.

So spend away everyone. Chances are inflation is on its way and your savings will be dropping in value soon enough anyway.

Julie Rains's picture

I think what I thought was interesting about Friedman's theory is that many people were borrowing with eventual plans to repay based on income generated from a home sale, which was supposed to increase in value to pay off all debt and generate a lump sum that could then generate earnings through investments. In many cases, the "permanent income" projections turned out to either be wrong or possibly unsustainable for certain periods of time. Btw I had already written a post on credit that mentioned considering not just the cost of credit per month (which is the first thing to do) but consider the entire cost of credit over the life of the loan for the Financial Literacy project (my date is April 27.)

Guest's picture
Kelja

Taxes suck, plain & simple. If you believe government has the right to collect taxes for the common good, then everyone should be liable for paying taxes. Everyone. The founders wrestled with this problem, some only wanting male property owners to have the right to vote. They understood intuitively that you have to have a stake in the outcome to be able to have a say in what happens.

Today, most people don't pay taxes. Yet many of those who don't pay still get benefits. This has skewed the process. Now, people who get the benefits but don't share the burden have no problem with voting themselves further benefits.

This will end badly.

Fred Lee's picture

Thanks for sharing your thoughts. Yes, taxes and the economy are a sensitive subject, and in the end, we'd all prefer to pay less taxes. Rhiannon, I agree that if I were to receive a lump sum, it would be more tempting for me to save it or pay bills, but that hasn't stopped me in the past from spending it on a night on the town. Now that I'm a family man, I'm less incllined to do that.

Julie, thanks for your wisdom and feedback, it's always much appreciated. And I agree with your insight about the cost of a loan over it's lifetime, and on the flip side, I think the capital gains on your house should be considered along these lines, as well. This would give a more grounded and realistic return on your investment, unless of course you're planning on flipping it quickly.

Rosa, whatever you do, don't stop having fun, and keep in mind, it doesn't always take money.

The Economist, thanks for sharing your info about the Austrian School. That's very interesting and I'll check it out. And I agree that our economy was based on this reckless notion of unlimited spending and consumption that could not be sustained, so once the inevitable contraction hit, it wasn't realistic to return to the way things had been, nor was it necessarily desirable. It should be interesting to see where this all leads.

And Kelja, I agree that taxes are a drag, but I would argue that few of us actually escape paying them in some form, whether it be sales tax, gas tax, or income tax.

Thanks to everyone for stopping by and sharing your thoughts.

Guest's picture
Guest

I predict no effect. Little increases and/or targeted taxes (beer tax increase or Tabbaco tax increase or hunting fee increases etc.) will counter any increase in take-home pay from the minor tax cut.

Any stimulative effect is wiped out by the fee/tax increases elsewhere.

Since a fair number of the taxes are highly regressive (cig's for example) the people most likely to spend the smaller weekly amounts (lower income folks) will be the most likely to have their 'tax cut' spent on new fees and taxes.