January
2008 Quarterly Forecast > 2008 Tax Rebates
Congress Saves the Day, or Too Little, Too Late?
By Ryan Ratcliff
While there’s still quite a bit of debate around whether or not we will actually see a U.S. recession in 2008, almost every observer will agree that we’re in for a bumpy ride that includes sluggish GDP growth (the UCLA Anderson Forecast’s prediction is 1.9% for 2008), elevated unemployment, and continuing carnage in the financial markets. With this sort of prognosis for 2008, it’s no surprise that much of the talk in Washington and on the campaign trail has turned to what the government can do to minimize the damage.
We economists and the Federal Reserve have been fretting about this question much longer than you might think. The decline in housing construction has shaved about 1% off of real GDP growth since mid-2006, which was also around the time the Fed switched from its strategy of slow but steady increases in the Federal Funds rate to standing pat at 5.25%. While the Fed’s primary worry in the first half of 2006 was that inflation would continue its slow upward creep out of Bernanke’s comfort zone, the increasing weakness in residential investment suggested that risks of further inflation versus an economic slowdown were probably pretty even, leading to this split the difference strategy of staying put at 5.25%.
By summer of 2007, the wave of mortgage defaults and the ensuing financial turmoil seemed to have made up the Fed’s mind: the risk of a recession now outweighed the possibility of more inflation, and led the Fed to cut the funds rate by 1% by year’s end, with another 1.25% cut so far in January. There’s a fair amount of debate among economists about what share of the motivation for these cuts came from shoring up the financial system versus a concern about GDP growth per se. But whatever the motivation, the end result is the same – the Fed has been stimulating the economy since the summer of 2007 in hopes of minimizing the fallout from the housing slump.
Unfortunately, one of the biggest problems with trying to stimulate the economy with lower interest rates is that it takes a long time: 12 - 18 months by some estimates. The path from a Fed Funds cut to the increases in investment and net exports (and potentially consumption) that the textbooks tell us will materialize is long and winding, running through the connection between short and long run interest rates, the balance sheets of banks, the globalization of capital markets, and even changing attitudes towards risk -- there’s many a slip ‘twixt the cup and the lip.
So it’s in this climate of waiting for some response to six months of monetary stimulus that we come to the current debate about a fiscal stimulus. First, let’s review the basics of the stimulus package as agreed to by the House of Representatives (the Senate was still debating at time of press). It calls for 2008’s tax rate on the first $6000 of income (the first $12,000 of joint income) to be reduced from 10% to 0%, and be distributed as a rebate check. Rebates will also include an additional $300 per child. There are several provisions for phasing out the rebate for high income payers. While the IRS has been skeptical about their ability to mail this many checks until well after the tax rush, Treasury Secretary Paulson has promised that the rebates can be sent out 60 days after the package becomes law. The grand total for these rebates comes to $100 billion, with an additional $50 billion targeted at stimulating investment spending through tax incentives. For reference, nominal GDP was $13.9 trillion in 2007Q3. Thus, the total tax cuts on the table represent about 0.7% of the total U.S. economy.
Does a tax cut representing 0.7% of the economy have enough “oomph” to offset the weakening components of GDP? Judging from the man-on-the-street interviews, many American feel that an extra $600 really won’t make much of a difference. But the stimulative effects of the tax cut don’t stop with that first purchase: the new TV that you buy is income in the pocket of the owner(s) of the TV shop, who go out and spend some of that extra income, giving more income to more people, and so on. When we teach economics, we often like to wow our students with estimates that a $1 tax cut could be multiplied to $9 in new GDP when all is said and done, but these estimates ignore taxes and imports and a variety of other ways that extra income can leak out of the system. “Real world” estimates of the tax cut multiplier vary widely: in the popular Data Resources Incorporated (DRI) model, this multiplier varies from 0.2 to 1.2 after four quarters (i.e. that our $150 billion tax cut will raise GDP anywhere from $30 to $180 billion one year out).
There are several reasons for this ambiguity. The first is how the Fed reacts to the fiscal stimulus. If the Fed does nothing, we get the 0.2 multiplier: the tax cut stimulates spending, but increases interest rates as the federal deficit places higher demands on a limited pool of investable funds. The lower spending caused by these higher interest rates offsets much of the fiscal stimulus. If the Fed maintains a constant interest rate (i.e. intervening to keep interest rates from rising), we get the full 1.2 multiplier as government spending no longer “crowds out” other forms of spending. Given the Fed’s recent rate cuts, the 1.2 case seems much more apropos here – with inflation worries taking a back seat, it seems likely that monetary and fiscal policies will both be pulling in the same direction, allowing the tax cuts to have their maximum impact.
However, there’s another complication that could potentially negate much of the stimulative effects of the tax cut: its widely trumpeted temporary nature. Most modern theories of consumer behavior acknowledge some amount of consumption smoothing: consumers use borrowing and lending to keep their consumption levels smooth in the face of income changes. If an increase in income is deemed to be permanent, they will increase consumption by most of the amount of the income increase. If consumers think the increased income is only temporary, they are more likely to save most of the income (or pay off prior debts) in order to turn the windfall into higher consumption over future periods. We last saw this same combination of aggressive interest rate cuts and temporary tax rebates in 2001Q3. Proponents of tax rebates argue that consumption’s contribution to overall GDP growth rose from 0.67% in 2007Q2 to an average of over 2% in the next three quarters. However, we economists are especially vulnerable to the post hoc, ergo propter hoc fallacy -- we need to be very careful about mistaking temporal ordering for causation. For instance, the consumption boom in late 2001 was driven in no small part by the 0% auto financing offered in the wake of September 11th. More careful microeconomic studies of the 2001 rebates are largely mixed. One survey analyzed by economists from Michigan (Shapiro and Slemrod) seems to support our worries about consumption smoothing: 78% of respondents said they planned to either save their rebate, or use it to pay off debt. However, another study finds that households spent between 20-40% of the rebates in the quarter the rebates arrived.
While the tax rebates represent the bulk of the stimulus package, there are also two other components of note: a tax incentive for business investment, and a potential increase in the value of mortgages that can be purchased by Fannie Mae and Freddie Mac. The $50 billion of investment incentives are essentially a tweaking of the accounting treatment of depreciation, and are designed to entice firm’s to shift forward purchase of equipment and software – a potentially potent one-two stimulus to business investment when paired with lower interest rates. But even with all of these incentives to increase investment, it will likely prove difficult to entice most firms to expand capacity on the cusp of a period of weaker demand for their products. While these incentives may provide a small boost to investment spending, we remain skeptical that this increase will alter the trajectory of the economy in 2008.
The increase in the purchase limits for Freddie and Fannie are potentially more promising, especially for California (and particularly the Bay Area). The current limit is $417,000. In the U.S. overall, mortgages eligible for purchase by one of these government sponsored entities (GSE’s) account for just under 70% of all mortgages. Of course, $417,000 doesn’t get you very far in California: only 45% of all mortgage here fall under this conforming limit, leaving the majority of home purchases to be financed through private jumbo loans, piggyback loans, etc. Unfortunately, mortgage markets have totally seized up in 2007: virtually the only mortgages anyone is willing to originate anymore are ones that can be sold to the GSEs – no one else is buying. Given California’s forced reliance on non-conforming loans, this credit crunch has hit home sales in California harder than just about anywhere else in the U.S. While the exact increase in the conforming limit is still being debated, most of the proposals are an increase to at least $600,000 – well over the median home price in California, even today. Obviously, there are a multitude of other factors that will keep housing markets weak in 2008. But while this policy won’t cure our housing ills overnight, it will go a long way to breaking the financing logjam here in California, which is an important first step in our housing recovery.
So what’s the bottom line here? While we find the arguments that much of these rebates will be saved instead of spent persuasive, this summer’s potential combination of some increase in consumer spending plus the long-awaited impact of last summer’s rate cuts will provide the economy with a much needed boost. However, it’s not a silver bullet: even with this stimulus package, we still foresee a very sluggish economy in 2008. We have argued for some time that the housing sector by itself cannot generate enough weakness to create a full-blown, 20th-century-style recession, and we maintain that forecast even now. However, we do acknowledge that the probability of recession is running uncomfortably high, and that Washington’s two-fisted approach to stimulating the economy provides some welcome insurance against that chance in 2008.
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