Thursday, August 5, 2010

Krugman almost always explains it best

Couldn't help but link to this blog post by Paul Krugman discussing why letting the high-income tax cuts expire is good policy. I'll let the Nobel prize winner speak for himself:

The basic framework we have for thinking about consumer spending goes back to none other than Milton Friedman, whose “permanent income” hypothesis says that people will save most of any income change they see as merely transitory. Telling rich people that we’ll keep their taxes low for a couple more years is, for them, a transitory income gain; they’ll save the bulk of it.

Isn’t the same true for lower-income people? Not to the same extent. Permanent-income reasoning doesn’t fully apply when some people are “liquidity-constrained” — they have depressed income, which would make them want to spend more than they earn right now, but they’re out of assets and unable to borrow, or unable to borrow except at relatively high interest rates. People in that situation will spend much or all of any temporary windfall.

So if we give money to people likely to be liquidity-constrained, they are likely to spend it. That’s why aid to the unemployed is an effective stimulus; it also suggests that tax cuts for lower-income workers will be relatively effective at raising demand. But the affluent, who typically have lots of assets and good access to borrowing, are much less likely to be in that situation.


For those that disagree, please identify the accepted counter theory against what Mr. Friedman outlined.

1 comment:

Colin said...

Telling rich people that we’ll keep their taxes low for a couple more years is, for them, a transitory income gain; they’ll save the bulk of it.

I agree with Krugman! The tax cuts should be permanently, not temporarily, extended. We need to change the long-term incentives, not engage in temporary Keynesian nonsene.