By Jan Hatzius, a fund manager at Goldman Sachs Following the Republican victory in the mid-term...
By Jan Hatzius, a fund manager at Goldman Sachs
Following the Republican victory in the mid-term elections, significant fiscal stimulus has become more likely. This is one reason why we do not expect the FOMC to cut interest rates at the 10 December meeting.
But even though the administration is now in a better position to push through additional tax cuts, the amount of stimulus that fiscal policy will provide over the next year remains unclear. This is because the prospect of fiscal stimulus comes with two caveats.
First, the form of the tax cuts matters a lot. In our view, the biggest imbalance in the US economy is the low personal saving rate of only 4%. Assuming returns on existing assets in line with the historical average, we estimate that consumers will need to save between 6% and 10% of their disposable income if they want to see their wealth grow in line with their income in the long term. The risk is that this rise in the desired saving rate leads consumers to cut their spending, pushing the economy back into recession.
The federal government could help reduce this risk through a broad and front-loaded personal income tax cut. This would give households the means to raise saving without having to cut spending. Extending unemployment benefits would also help in this regard.
Does the finding that consumers may only have spent a small percentage of the 2001 tax rebates mean that these tax cuts were a failure? In our view, the answer is no. If tax cuts make the current level of spending more sustainable, that is already significant progress given the size of the saving imbalance.
Compared with broad personal income tax cuts, other fiscal measures that are currently being considered look less promising. Making the existing tax legislation permanent beyond 2010 would have virtually no effect on current spending ' it is neither plausible nor empirically documented that tax law changes eight years into the future make a difference for current spending and saving decisions.
Tax cuts for investors or changes in the taxation of dividends would probably only have a modest impact on spending, although they may well be sensible from a long-run tax systematic perspective. This is because most of the benefit would go to higher income earners or companies, whose marginal propensity to spend out of an additional dollar of after-tax income is lower than that of lower-income individuals.
Second, state and local restraint might offset federal stimulus. Unfortunately, fiscal restraint at the state and local level is likely to offset a large part of any additional federal stimulus. The problem is that most state and local governments are subject to balanced budget laws that prohibit current deficits ' in other words, governments can only borrow in order to finance capital projects.
As a result, we expect real state and local spending to stagnate in the next year, which would be a worse performance than during the 1990-1991 recession.
Significant fiscal stimulus likely.
Personal income tax cut would act as stimulus.
Unemployment benefit rise may help economy.
Most state laws prohibit currency deficits.
Dividend tax cuts woud not reduce spending.
Rise in savings rate may push US into recession.
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