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Economic Stimulus: What fiscal stimulus options should be avoided?

Some fiscal measures would do very little to boost economic activity during a downturn, either because they would take too long to have any effect or because they would give additional spending power to households who are less likely than others to increase their spending. Such policies might even make the economy worse off in the long run if they increase the long-run government deficit, causing interest rates to rise and so reducing investment.

  • Reduce tax rates. Permanently reducing tax rates would generate less than half as much economic stimulus as a flat, refundable tax credit of the same size. It would also give disproportionate benefits to high-income households, the least likely to be hurt by a downturn. A permanent tax reduction could also raise long-term interest rates and crowd out some of the modest direct stimulus.
  • Make the 2001 and 2003 tax cuts permanent. The tax cuts enacted in 2001 and 2003 expire at the end of 2010. Making those cuts permanent would violate all three principles of effective fiscal stimulus-they would be neither timely, nor temporary, nor well targeted-and might even hurt the economy in the short run, for several reasons. First, a reduction in income taxes starting in 2011 would provide little boost to consumer spending in 2008. Second, the 2001 and 2003 tax reductions offered the largest dollar benefits to the highest-income families, so extending them would provide little stimulus bang for the buck even in 2011, because those families tend to save more of an unexpected increase in income. Third, a permanent tax change would increase the long-run budget deficit, likely reducing long-run economic growth. Worse, if the financial markets conclude that the policy will raise the long-run deficit, interest rates would rise today, crowding out investment and reducing GDP in the short run as well.
 
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