Stimulus: Spending or tax cut?

While some advocate more spending but others instead favor tax cut as a stimulus to the ailing economy, what is better? What combination is good? I will try to take a qualitative view on the merits of each, leaving to quantitative view to those with established and powerful models.

As written on September 30 and October 12, of the four pillars of the economy, consumption, investment, net exports and government spending, the first 3 are not growing. Let's examine the situation of each sector below:
- In this consumer-led recession, consumption is primarily affected by people losing jobs, the difficulty to borrow, and the fear that things will get worse, so spending is delayed.
(i) For people losing jobs and can't even spend on essentials, tax cuts would not help them directly. Extending unemployment benefits would help them spend on essentials, which helps to keep other people's jobs.
(ii) The difficulty in borrowing stems from (1) financial institutions questioning people's repayment capability and capacity, due to the job cuts or salary cuts as a result of the ailing economy, and (2) the declining asset base on the balance sheet of many financial institutions that make lending less available. (Therefore, capital injection to those institutions on the edge of insolvency, so they could be solvent or buying toxic assets from those healthier so that the market and counterparties have more confidence in investing or deal with them. Otherwise, healthier banks are lumped into the same group as unhealthy banks because outsiders cannot tell which institution is sound. But let's leave that to another discussion.)
(iii) For those with the means to buy, many are holding back because of the fear that things will get worse or that they will lose their jobs (which is a widespread sentiment as reported by recent market surveys). As such, they are either rebuilding their war chest, saving for rainy days down the road, or paying down debt upon realizing the potential dire straits they could be in. A tax cut will not really help, since whatever amount that is retained will likely not be used for purchases. A permanent tax cut will not really help either, since if people lose their jobs, they will not benefit from any permanent tax cuts. Hence, keeping their jobs is key.

On the investment side, housing and business investments are in general not picking up.
(i) On housing, buyers' sentiment is in part similar to consumption in that it is a question of whether they can afford it and whether they should invest now. Of course, the other factor is bank's general reluctance to lend. Of course, if house prices fall enough, more buyers will emerge, but most will still be affected by their outlook on the stability of income going forward.
(ii) On business investment, having a strong current demand and having more certainty about the future (just like consumers) help with the investment appetite. With consumers down the value chain not really spending, investments, in most cases, will unlikely help with spurring demand. Investing in productivity improving equipment and such could help lower cost, which could mean more sales, but it also depends on whether consumers will spend and buy. In addition, in the initial stage of productivity improvement, more workers are not needed unless sales increase to an extent that the current staff cannot effectively handle the increased demand. For taxes, lower interest rates lower the cost of operation in ways similar to a business tax cut, loosely speaking. If long term rates are lowered, as a result of the Federal Reserve buying long-dated treasuries, the longer term cost of capital will be lower as well. Tax cut or not, if the difficulty in borrowing persists or that demand continues to be weak that threaten the survival of companies, a permanent tax cut, will not help company realize this permanent increase of retained earnings.

On the net export side, (i) the stronger dollar, due to weaknesses in other countries and that the USD is considered as a safe haven, (ii) weakness in lending to continue or expand operations, and (iii) the weakness in global demand are all hurting this sector. Factors affecting the business investment side are similarly affecting many businesses in the export sector. In addition, many goods still cost less to produce outside of the U.S., so consumers hoping to save money will more likely opt for cheaper alternatives, produced mostly outside of the U.S. "Buy American" sounds good as a slogan, but how many consumers will pay more in most cases, instead of saving money.

As such, that consumers, investment and net exports are not driving growth, then the government, in this uncertain and down market, is the entity left that could act as one, create jobs (so that people can spend, which in the process helps keep some existing jobs or create new ones.), have a much longer term horizon and have access to a lower cost of capital than other businesses.

Spending helps preserve and/or create jobs. When people, like businesses, have more certainty about their future, they are more willing to buy and invest. Buying helps merchants and their workers. Consumer buying causes businesses to buy from suppliers, all the way down the value-chain and so on.

It is not a surprise that many respected economists on the Republican side, such as Martin Feldstein, are in favor more spending and less tax cuts.