The Federal Tax Credits Blog

Question: explain the economic rationale for enacting a large fiscal stimulus package?

The recently passed (Winter, 2009) “American Recovery and Reinvestment Act” contains a mix of tax rebates, tax credits and increases in various transfer payments (such as extension of unemployment compensation). It also contains funding for a large number of infrastructure spending projects and some funding for scientific research. Most republican legislators voted against the proposed stimulus bill on the grounds that it should have contained more tax cuts and less infrastructure/research spending.

A) Briefly explain the economic rationale for enacting a large fiscal stimulus package at this time.

B) Compare and contrast the “multiplier effects’’ on AD of $1 billion of tax cuts/transfer increases with the multiplier effects on AD of $1billion of increased infrastructure spending. Assume in both cases that the timing of the tax cuts/expenditures occurs over a 2 year period.

Answer: A) During economic recession, people are afraid to spend money and so will instead save more of it (in case they lose their job, for instance). As a result, the Marginal Propensity to Consume of most people sharply drops. However, the MPC of Congress is always 100%, and because spending is what drives an economy out of a recession (because it shifts Aggregate Demand to the right, increasing output/GDP), it is beneficial to the economy to have more government spending.

B) Assume the average citizen’s MPC is 75%. When 1 billion dollars are given directly to consumers in tax cuts, that money will be spent continually, with the MPS of 25% for each step it is transferred. From the multiplier effect, we can see that the total amount added to the economy will be the original amount spent+$4 billion, making a total of $4,750,000,000. The same occurs when the government spends the money, except that the original amount spent will be greater, for a total addition to the economy of $5 billion.

Extension of U.S. Tax Cuts Will Prompt Congress to Discard Own Budget Law

Congressional Democrats and Republicans are preparing to set aside their budget constraints as they negotiate the extension of income tax cuts scheduled to expire this month.

Closing Extension Passed by Senate June 30th.mpg

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