Short-Run and Long-Run Stimulus in a Single Measure

In the short run, we want households to consume more. In the long run, we want them to save more. Passing a progressive consumption tax now to take effect later provides incentives for both.

In yesterday’s post I advocated a progressive consumption tax to help pay down growing federal budget deficits. An ancillary effect of adopting this tax would be to stimulate domestic savings, low levels of which helped precipitate the current downturn.

Of course, with the economy in the deepest downturn since the Great Depression, the immediate imperative is to increase spending, not reduce it. If we adopt a progressive consumption tax, we should phase it in only after the economy recovers.

Even then, some worry that a progressive consumption tax would dampen the consumption spending often described as the foundation of our economic prosperity. But consumption is not the cause of our prosperity; it is a consequence of it. If the tax were phased in gradually, its main effect would be to shift the composition of spending from consumption to investment. Because it is total spending, not just consumption, that determines output and employment, there would be just as many jobs as before the shift.

More important, by stimulating additional investment, a progressive consumption tax would also cause productivity and incomes to rise faster over time. Consumption would be a smaller fraction of income than before, but because of the higher growth resulting from higher investment, the new absolute consumption trajectory would quickly overtake the earlier one. If you like to consume, and most of us do, shifting from a borrow-and-spend economy to a save-and-invest economy is the best way to boost consumption in the long run.

By strategically timing the implementation of a progressive consumption tax, the government could thus promote both short-term stimulus and long-run revenue growth in a single stroke.

Suppose, for example, that the president signed a law this year calling for a progressive consumption tax to take effect the moment the national unemployment rate had again dipped below a threshold level, such as 6 percent. Any family that was contemplating a large purchase in the coming years would then have a powerful incentive to spend that money right away, so as to avoid the consumption levy.

Note the striking contrast between that incentive and the incentives confronting families under traditional stimulus measures, such as temporary income tax rebates. As experience has shown, people who are fearful about losing their jobs are likely to save such rebates or use them to pay down existing debt.

Most economic policy instruments confront us with painful tradeoffs between short- and long-term objectives. A strategically implemented progressive consumption tax is a conspicuous exception. By confronting families with powerful incentives to increase spending right away, it would reduce the demand shortfall that is currently holding the economy back.

Once the economy again reaches full employment and the tax starts being phased in, it would shift the economy’s focus gradually from consumption to investment spending, which would stimulate additional growth in both income and tax revenue. And should another recession occur, a temporary cut in consumption taxes would provide a much more powerful stimulus than the traditional remedy of a temporary cut in income taxes.

Author: Robert Frank

Robert H. Frank is the Henrietta Johnson Louis Professor of Management and Professor of Economics at Cornell's Johnson Graduate School of Management and the co-director of the Paduano Seminar in business ethics at NYU’s Stern School of Business. His “Economic View” column appears monthly in The New York Times. He is a Distinguished Senior Fellow at Demos. He received his B.S. in mathematics from Georgia Tech, then taught math and science for two years as a Peace Corps Volunteer in rural Nepal. He holds an M.A. in statistics and a Ph.D. in economics, both from the University of California at Berkeley. His papers have appeared in the American Economic Review, Econometrica, Journal of Political Economy, and other leading professional journals. His books, which include Choosing the Right Pond, Passions Within Reason, Microeconomics and Behavior, Principles of Economics (with Ben Bernanke), Luxury Fever, What Price the Moral High Ground?, Falling Behind, The Economic Naturalist, and The Darwin Economy, have been translated into 22 languages. The Winner-Take-All Society, co-authored with Philip Cook, received a Critic's Choice Award, was named a Notable Book of the Year by The New York Times, and was included in Business Week's list of the ten best books of 1995. He is a co-recipient of the 2004 Leontief Prize for Advancing the Frontiers of Economic Thought. He was awarded the Johnson School’s Stephen Russell Distinguished teaching award in 2004, 2010, and 2012, and its Apple Distinguished Teaching Award in 2005.