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Why the Tax Cut Didn't Stimulate More Spending

Monday, 28 Feb 2011 | 1:54 PM ET
US Capitol Building with cash
US Capitol Building with cash

Consumers increased spending 0.2 percent in January, despite a cut in Social Security taxes that grew personal income by a full percentage point.

You’ll hear lots of theories about why consumers didn’t spend more of the increased income. But don’t read too much into the news.

A big boost in spending was simply never in the cards. I pointed this out back in December, after Deutsche Bank’s economists argued that the tax cut would result in over a $100 billion in additional spending.

The silent assumption here is that consumers will spend their increased income from the payroll tax holiday in the same way they spend their regular income. That assumption, however, is way too optimistic. In the first place, as good old Milton Friedman taught us, people tend to spend based on their expectations of future income instead of on the reality of current income. One of the lessons of this is that temporary tax relief doesn’t increase spending by much because people know that their future income will take a hit when the tax comes roaring back.

What's more, the form that this particular tax cut took guaranteed meager results. Spending increases more when people receive large rebate checks than when they see a small raise in their paychecks.

Some economists, including those guys at Deutsche Bank, are no doubt surprised by today's news. They shouldn't be.

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