Order Code RS21126
Updated January 23, 2007
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 recent fiscal stimulus bills. Among tax cuts discussed or enacted in the 107th and
108th Congress were 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, the stimulus bill enacted in March of 2002), and
corporate tax cuts (primarily repealing the alternative minimum tax). President Bush
proposed accelerated rate cuts and dividend relief in his stimulus package, which was
enacted in 2003, while proposals such as rebates have been made by Democratic leaders.
Economic stimulus proposals were also discussed in 2005 following Hurricane Katrina,
and, although the economy is in a growth phase, could arise in the future. 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 were discussed during consideration of the fiscal
stimulus in the 107th and 108th Congress. Some were included in various versions of the
stimulus tax cut legislation in 2002 and 2003 and some of the debate 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, corporate tax cuts (primarily repealing the alternative

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minimum tax), and dividend reductions. The final version of the 2002 tax cut bill
included a temporary investment stimulus. President Bush proposed accelerated rate cuts
and dividend relief in his stimulus package for 2003. Proposals such as rebates were
made by Democratic leaders. Although the economy recovered from the recession, issues
of fiscal stimulus arose again in the 109th Congress in the wake of Hurricane Katrina, and
will likely be of concern in the future.
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. Dividend relief will also be
concentrated on higher income individuals.
(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 increments (e.g. through withholding). This effect
could make a 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

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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.
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).
1 See Martin Browning and Annamaria Lusardi, “Household Savings: Micro Theories and Micro
Facts,” Journal of Economic Literature, vol. 34 (Dec. 1996); and John Sabelhaus and Jeff Groen,
Can Permanent Income Theory Explain Cross Section Consumption Patterns?, Congressional
Budget Office, Technical Paper 1997-3, July 1997.

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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
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
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 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 (Nov. 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
(Sept. 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, Jan. 2002.
4 See Nicholas Souleles, “The Response of Household Consumption to Income Tax Refunds,”
American Economic Review, vol. 89 (Sept. 1999), pp. 947-958; and Nicholas Souleles,
“Consumer Response to the Reagan Tax Cuts,” forthcoming, Journal of Public Economics.

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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.
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.
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.

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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.
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 this 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 (Mar. 1998), pp. 193-225.

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