Order Code RS21126
Updated April 2, 2002
CRS Report for Congress
Received through the CRS Web
Tax Cuts and Economic Stimulus:
How Effective Are the Alternatives?
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
Several different types of tax cuts have been debated during the consideration of the
fiscal stimulus bill, which was eventually enacted in early March 2002 (H.R. 3090).
Among the tax cuts discussed are tax rebates targeted towards lower income individuals,
a speed-up of already planned tax rate reductions for higher income individuals, a
temporary sales tax holiday, a temporary payroll tax holiday, a temporary investment
stimulus (which was ultimately included in H.R. 3090), and corporate tax cuts (primarily
repealing the alternative minimum tax). A tax cut is more effective the greater the
fraction of it that is spent. Empirical evidence suggests individual tax cuts will be more
likely to be spent if they go to lower income individuals, making the tax rebate for lower
income individuals likely more effective than several other tax cuts. There is some
evidence that tax cuts received in a lump sum will have a smaller stimulative effect than
those reflected in paychecks, but this evidence is limited and the results subject to some
reservations. While temporary individual tax cuts in general are likely to have smaller
effects than permanent ones, temporary cuts that are contingent on spending (such as
temporary investment subsidies or a sales tax holiday) are likely more effective than
permanent cuts. (Sales tax holidays may, however, be very difficult to implement in a
timely fashion). The effect of business tax cuts is uncertain, but likely to be quite small
for tax cuts whose main effects are through cash flow. This report will be updated as
events warrant.
Several different types of tax cuts have been discussed during consideration of the
fiscal stimulus. Some have been included in various versions of the stimulus tax cut
legislation (H.R. 3090, H.R. 3529 and H.R. 622 as amended) and some of the debate has
centered on the effectiveness of alternatives. Among the tax cuts discussed are tax rebates
targeted towards lower income individuals, a speed-up of already planned tax rate
reductions for higher income individuals, a temporary sales tax holiday, a temporary
payroll tax holiday, a temporary investment stimulus, and corporate tax cuts (primarily
repealing the alternative minimum tax). The final version of H.R. 3090 included a
temporary investment stimulus.
Congressional Research Service ˜ The Library of Congress

---

CRS-2
Effectiveness of a tax cut for short run stimulus purposes is judged by the extent to
which the tax cut increases private demand (either consumption or investment spending).
A tax cut that is saved will have no short term stimulative economic effect (or long term
one, if the cut is financed by a deficit, since increased private saving would be offset by
decreased government saving). Thus, in general, tax cuts received by individuals will not
be successful as a short run stimulus if they lead to additional saving, and tax cuts received
by firms will not be successful unless they lead to spending on investment (or lead quickly
to spending on consumption by shareholders).
The following four propositions can generally be supported by economic theory and
empirical evidence:
(1) Individual income tax cuts directed at lower income individuals will likely have a larger
effect than cuts directed at higher income individuals, other things equal. This
distributional effect suggests that the most effective tax cut would be a rebate which is not
only a flat amount but specifically directed at lower income individuals (who did not have
tax liability). While payroll and sales taxes are more concentrated among moderate and
lower individuals than the normal income tax, they are largely proportional taxes and the
bulk of them will still go to middle and higher income individuals. Most income tax cuts
actually exclude the bottom 20% of the population who do not pay income tax. The
speed-up of rate reductions will be concentrated among the top 30% of those who do pay
the income tax.
(2) There is weak empirical evidence that a lump sum tax cut is less likely to be spent than
one that is received in small amounts increments (e.g. through withholding). This effect
could make the rebate less effective than alternative individual tax cuts if it were not for
the distributional evidence. However, the distributional effect is more solidly grounded
in economic theory, and is based on more concrete and extensive empirical evidence.
(3) Certain types of temporary tax cuts are likely to be more effective than permanent ones
while, in other cases, they are less effective. The most important illustration of this effect
is a temporary investment subsidy, but it could also apply to a temporary sales tax holiday
or any design where spending is required to obtain the subsidy and is for a limited
duration. Otherwise, temporary cuts are likely to be less effective than permanent ones.
(4) Corporate tax cuts that do not make new investments more profitable are unlikely to
have much effect on investment or consumer spending, especially when the economy is in
a recession.
The remainder of this report provides a summary of the evidence and economic
reasoning supporting these propositions. Before discussing these propositions, however,
it is important to note the differences between a model where individuals consume based
primarily on current income compared to those where individuals consume primarily out
of permanent (lifetime) income, because much of the empirical analysis focuses on this
issue. Optimal lifetime consumption models imply that consumption is based on permanent
income and suggest very little will be spent out of transitory income (because it has little
effect on permanent income). Thus, a temporary tax cut, which is the normal mode of a
fiscal stimulus, would be ineffective. Extensive empirical investigation has rejected this
permanent income model in its pure form and suggests that consumption responds to
permanent and current income.

---

CRS-3
Proposition 1: A tax cut directed at lower income individuals should have a larger
effect on spending than one directed at higher income individuals.
Data show that the fraction of income saved rises as income rises. For example, the
saving rate in the top 1% of the income distribution is over 10 times the rate in the lowest
20%, and is almost three times the average.
This pattern is far too pronounced to be accounted for by business cycle reasons and
cannot be explained by life cycle patterns and thus, itself implies a departure from the
permanent income model of consumption.1 A saving rate that rises across incomes could
be expected even in a permanent income model if each individual has the same permanent
saving rate. At any time, some individuals may be earning lower than average amounts
and others higher than average amounts. Thus the transitory income would understate
permanent income in some cases and overstate it in others. Since more individuals with
unusually low incomes would fall into the lower groups (and more with higher incomes
into the high groups), some pattern of rising saving rates is expected. But empirically the
effect is far too large to be explained by this phenomenon (which can be examined by
looking at variations over time for an individual). A rising saving share with income could
also arise from life cycle reasons. Typically income is low in the early years of life, rises
during the working career and falls at retirement. If individuals want consumption to be
smoother than income, they will save less when they are young and old and have lower
incomes, and save more in the middle when they have higher incomes. However, when
examining the data, we find that age does very little to explain saving behavior and the
patterns of rising saving rates with income persist within age groups.
Aside from these empirical observations, there are theoretical reasons to expect that
lower income individuals are likely to spend more of an additional dollar of income than
do higher income individuals, especially in the case of a temporary tax cut, which is the
kind of cut normally associated with fiscal stimulus. They may have a lower lifetime
saving rate because social welfare programs are likely to have a higher wage replacement
rate during instances of bad luck (e.g. disability) or old age and because they are less likely
to wish to leave bequests. Indeed, for some means-tested programs, assets can disqualify
an individual from coverage. They may have less information with which to optimize over
time and, if they save at all, simply have a target amount (at least in the short run), so that
additional income is spent (including temporary income increases). Finally, they are more
likely to be subject to liquidity constraints; that is, to prefer to spend more than their
earnings and not be able to because they cannot borrow and have no assets. Indeed,
permanent income theories suggest that for a temporary tax cut, tax cuts for non-liquidity
constrained individuals may have virtually no effect, while tax cuts for liquidity
constrained individuals will be largely spent.2
1 See Martin Browning and Annamaria Lusardi, “Household Savings: Micro Theories and Micro
Facts,” Journal of Economic Literature, vol. 34, December 1996; Congressional Budget Office,
“Can Permanent Income Theory Explain Cross Section Consumption Patterns?,” Technical Paper
1997-3, John Sabelhaus and Jeff Groen, July 1997.
2 An extensive literature has addressed these issues. They are related to the empirical rejection,
by and large, that consumption is solely determined by permanent income, as occurs with rational,
optimizing models of consumer behavior in perfect capital markets (as reviewed in Brown and
(continued...)

---

CRS-4
Proposition 2. A tax cut provided through a lump sum payment may be less likely
to be spent than one which shows up in withholding, but the evidence is weak.
This differential effect (which would not occur in a permanent income model) was
pointed out by the Congressional Budget Office (CBO) in its recent comparison of the
effectiveness of alternative tax cuts.3 CBO referred to a comparison of results from two
studies that examined the effect of income tax refunds, and of expected rate cuts from pre-
announced tax cuts of the early 1980s.4 Both studies rejected the permanent income
model (suggesting some spending effects from a transitory tax cut), but larger effects were
found for the rate reductions.
There are, however, two reservations about comparing these two events to gain
insight into the effects of lump-sum tax cuts versus tax cuts reflected in paychecks over
time. First, to the extent that individuals use over-withholding as a means of forcing
themselves to save, one would not expect spending to rise when the refund is received,
even though it might rise when an unplanned rebate is received. Thus, finding a smaller
amount of spending out of a refund than out of tax cuts reflected in pay checks may not
be very meaningful. Secondly, the model assumes that individuals were certain that the
later phases of the Reagan tax cuts would be received. If there was some uncertainty,
however, the fact that spending did not increase until the tax cut was actually received may
partially reflect not the failure of the permanent income model, but the lack of certainty
about receipt of the cut.
2 (...continued)
Lusardi, cited above). These empirical tests generally find a smaller marginal propensity to
consume than is indicated by long run, economy wide savings rates, but nevertheless one far above
zero. Some economists have suggested that heterogeneity among consumers is responsible, that is,
that some individuals behave according to the rational optimizing model, while the consumption
of others is closely affected by current income. There is evidence that liquidity constraints play an
important role. In addition to the review in Brown and Lusardi, above, see N. Gregory Mankiw,
“The Savers-Spenders Theory of Fiscal Policy,” American Economic Review, Vol. 90, May 2000,
pp. 120-125 for a review and two additional papers that find support for liquidity constraint effects:
Jonathan A. Parker, “The Consumption Function Revisited” (working paper); and Jonathan
McCarthy, “Imperfect Insurance and Differing Propensities to Consume Across Individuals,”
Journal of Monetary Economics, Vol. 36, November, 1995, pp. 301-327. However, positive
results are not universally found including results in several recent studies (Nicholas Souleles, “The
Response of Household Consumption to Income Tax Refunds,” and Jonathan Parker, “The
Reaction of Household Consumption to Predictable Changes in Social Security Taxes,” both in the
American Economic Review, vol. 89, September 1999, pp. 947-958, and 959-973; Nicholas
Souleles, “Consumer Response to the Reagan Tax Cuts,” forthcoming, Journal of Public
Economics). Studies that have not found effects, however, have generally excluded or under-
represented low income individuals who are most likely to be liquidity constrained. In addition, the
Souleles study may be flawed if overwithholding is used as a form of forced savings by low and
moderate income individuals and the Parker study may be flawed if there are unmeasured seasonal
differences in spending by wealth.
3 Congressional Budget Office, Economic Stimulus: Evaluating Proposed Changes in Tax Policy,
January 2002.
4 See the Souleles articles discussed in footnote 2.

---

CRS-5
If a differential does indeed exist, this effect could make the payroll tax cut (and sales
tax holidays) more effective than a rebate. However, these “lump sum” effects would have
to be offset by the distributional effects discussed in proposition I and supported by
considerable empirical evidence. For that reason, it would be difficult to conclude that a
payroll tax holiday would be more effective than a rebate directed at low income
individuals.
Proposition 3. Certain types of temporary tax cuts may be more effective than
permanent ones.
In general, the permanent income modeling of consumption, even when it does not
hold in a pure form, suggests that temporary tax cuts will be less effective than permanent
ones, presenting something of a dilemma because, tax cuts motivated for fiscal policy
reasons need to be temporary (if they are not to hamper long term growth). However,
temporary tax cuts that depend on spending (rather than receiving income) are likely to be
more effective in the short run than permanent ones. During a period of slack
employment, a payroll or individual income tax cut is simply a temporary windfall which
can be spent at any time without any further consequence for the size of the tax cut. But
if the tax benefit is triggered by spending, a temporary tax cut will be more effective (just
as a temporary sale tends to induce a large response). The most common example is the
investment tax credit or a similar subsidy, such as temporary partial expensing of
investment, but the same would be true of a temporary sales tax holiday.
Note that while this feature may make a temporary tax cut more effective than a
permanent one, it does not mean that the stimulus is more effective than other alternatives
when all factors are considered. Most evidence suggests that investment subsidies have
a small effect on investment.5 And, it may be particularly difficult to induce investment
(even with a temporary subsidy) when excess capacity exists. While firms benefit from the
temporary subsidy, they lose the benefit of delaying cash outlays. If investment is
insensitive to these cost effects, a subsidy directed at increasing consumption may be more
effective even if the latter is not the type where the temporary nature provides a benefit.
In the case of the sales tax holiday versus other individual cuts, there may be a substantial
implementation lag in arranging the sales tax holiday since sales taxes are imposed by the
states, and fiscal stimulus may be applied at the wrong time. Moreover, the anticipation
of the holiday should be contractionary. That is, a pre-announced future temporary
spending subsidy is initially contractionary.
Proposition 4. Corporate tax cuts that do not make new investments more profitable
would not have much effect.
A repeal of the corporate alternative minimum tax with a refund of existing credits
does not necessarily make new investment more profitable; indeed, it is possible that new
investment may be subject to higher tax burdens under the regular rates than under the
lower rates in the AMT.
5 See CRS Report RL31134, Using Business Tax Cuts to Stimulate the Economy, for a survey of
the evidence and for a general discussion of different types of business tax subsidies.

---

CRS-6
Economic theory suggests that the investment decision should be driven by its
expected profitability. A tax decrease not associated with that profitability should have no
effect on investment. Rather, a tax decrease (which increases a firm’s cash flow) is more
likely to be spent on reducing debt, or paying out dividends. Both choices would not
expand aggregate demand.6

There is a potential constraint, however: if the firm does not have access to outside
capital or finds outside capital excessively costly, cash flow might have an effect on
investment. This effect would be likely, however, to be focused on small firms, and most
of the AMT is paid by large ones.

There is some empirical evidence of a positive relationship between firm investment
and cash flow. However, interpreting this evidence with respect to the effectiveness of a
corporate cash flow as a stimulus to investment spending during an economic contraction
is hampered by two important reservations. First, in most cases, cash flow is correlated
with the productivity of investment and investment growth, and investment may be
responding not to cash flow but to investment outlook. Secondly, even if there is some
independent effect of cash flow in normal circumstances, then whether an increase in cash
flow would induce a firm to make new investments during periods of excess capacity is
doubtful.7 In any case, a choice that is more focused on investment (such as an investment
subsidy) would have a more pronounced effect than one that is not.
Note also that some large multinational firms are subject to the AMT because of
limits on the foreign tax credit. Eliminating the AMT in their case would make investment
more attractive abroad, not in United States. Spending on investment abroad would not
directly increase aggregate demand in the United States, although it could have effects on
exchange rates and, eventually, on net exports.
6 It is possible that knowledge of a tax cut could induce stockholder’s consumption, or that cash
flow translated into dividends would do so, but this effect is delayed and less certain than a direct
tax benefit, as well as accruing to higher income individuals who are less likely to spend it.
7 For a survey of this issue, see R. Glenn Hubbard. “ Capital Market Imperfections and
Investment,” Journal of Economic Literature, vol. 36, March 1998, pp. 193-225.

---