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Treasury Notes

 A Look Under The Hood: Dissecting The Tax Cut / Unemployment Insurance Agreement

By: John Bellows
12/13/2010

President Obama and Congressional leaders recently reached a bipartisan agreement that will provide an important boost to the economy by cutting taxes and extending unemployment insurance.   As Congress prepares to take votes on the agreement, it’s worth asking: where does the crux of that boost come from? Because they are larger and better targeted, the  initiatives within the agreement favored by the Administration will provide at least five times more stimulus to the economy than the proposed tax cuts for high income households.

Although the economy has grown for five straight quarters and has added over a million new private sector jobs this year, the unemployment rate remains unacceptably high and real GDP is still below pre-recession levels.  In recent days, a wide range of independent analysts have concluded that the bipartisan agreement will increase growth and create jobs by boosting consumer spending and business investment.

A graphic posted Friday on the White House blog provided details of some components of the agreement, which includes $238 billion of the Administration’s initiatives that will be especially effective in stimulating the economy.  These proposals – including extended unemployment benefits, a payroll tax holiday and extensions of refundable tax credits – will put roughly twice as much money in the pockets of American families as the proposed tax cuts for high-income households. 

Moreover, the Administration’s proposals are targeted at working families who have been especially hard-hit by the recent downturn.  Because these families tend to spend most of an extra dollar of income, the Administration’s initiatives will have a high impact on output growth per budget dollar, providing more “bang for the buck.” 

In November 2010, the nonpartisan Congressional Budget Office (CBO) published a range of estimates of the “multiplier” effects of various tax and spending policies – including separate estimates for high and low income tax cuts – as part of its regular analysis of the impact of the Recovery Act.  These estimated multipliers capture the direct and indirect effects of tax cuts and spending increases.  For example, an extra dollar of unemployment benefits increases spending by the unemployed.  This increases retail sales, which increases income for workers making and selling consumer goods; these workers then spend more money, continuing the virtuous cycle.  In contrast, well-off households are less likely to spend an extra dollar from a tax cut, implying less of a boost to aggregate demand and growth. 

The CBO analysis suggests that the Administration’s proposals will have relatively large multiplier effects.  For instance, the CBO reports that each dollar of extra transfer payments to individuals – such as unemployment benefits – adds between 80 cents and $2.10 to the nation’s output.  They also estimate that a dollar of tax cuts for lower and middle income households – such as the proposed payroll tax holiday, which affects wages and salaries up to $106,800 a year – adds between 60 cents and $1.50 to output.  In contrast, the CBO estimates that a dollar of tax cuts for higher income households adds only between 20 and 60 cents to output.      

Combining this range of estimated multipliers with the dollar figures from the graphic in the White House blog post, the Administration’s initiatives will provide at least five times more stimulus to the economy than the proposed tax cuts for high income households.  

Other estimates of policy multipliers are available.  For instance, the CBO produced different multiplier estimates in their analysis of various stimulus options in January 2010.  Using those multipliers, the Administration’s proposals would generate five to seven times more stimulus than the proposed tax cuts for higher income households. 

At this critical time in the recovery, proposals designed to provide a high-impact boost to the economy are exactly what we need.

John Bellows is the acting Assistant Secretary for Economic Policy.

Posted in:  Economic Policy
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