Research Desk: Tax cuts as stimulus around the world

at 11:08 AM ET, 11/01/2011

Commenter sgwin1 asks:

Have any countries engaged in stimulus via drastically cutting consumption taxes, and if so have they been successful at increasing demand? I am wondering if a consumption tax tied to the unemployment rate would be a decent automatic stabilizer in future recessions.

The most prevalent consumption tax used abroad is the value-added tax (VAT), and what evidence I could find suggests that the stimulative bang-for-the-buck of VAT cuts is, though positive, lower than a number of alternatives. Dániel Baksa, Szilárd Benk and Zoltán M. Jakab estimated the multipliers for various fiscal policy measures in Hungary and found that a permanent decrease in the VAT had a multiplier of 0.45; that is, each dollar spent cutting the VAT grows the economy by 45 cents. The one-year multiplier for a temporary VAT cut, of the type an automatic stabilizer system would produce, is about the same. By contrast, the multiplier for an income tax cut was estimated at 0.8.

Similarly, the British Treasury estimates the multiplier for a VAT cut at 0.35. Both of these studies use modeling approaches; see here for the advantages and limitations of using modeling to evaluate the effectiveness of stimulus measures. All this said, one could also view proposals, such as former Obama budget director Peter Orszag’s, to tie the payroll tax rate to the unemployment rate, would effectively result in a “consumption tax tied to the unemployment rate.” In the long run, wages equal consumption, and so a tax on wages, such as the payroll tax, should amount to a consumption tax. The multiplier associated with payroll tax cuts is around 1.24, so it probably makes more sense for the United States to go this route rather than adopt a VAT and tie it to unemployment.

 
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