Tax Cuts for Short-Run Economic Stimulus: Recent Experiences

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Congress is considering an economic stimulus package that is likely to include individual tax cuts
and business tax provisions. In recent years, several different types of short run fiscal stimulus
measures have been enacted: an individual income tax rebate in 2001, a temporary investment
incentive (bonus depreciation) in 2002, and dividend relief in 2003. The February 2008 stimulus
included a rebate, bonus depreciation, and small business expensing.
Recent analysis and empirical studies suggest the 2001 rebate was an effective stimulus, bonus
depreciation had a limited effect, and, on theoretical grounds, dividend relief was unlikely to
provide an effective stimulus. Although there was not much obvious evidence of an effect on
consumption for the 2008, some preliminary evidence on the 2008 rebate suggests the rebate is
effective.

The 2001 Rebate..............................................................................................................................1
The 2002 Bonus Depreciation.........................................................................................................2
The 2003 Dividend Relief...............................................................................................................4
Preliminary Information on the 2008 Rebate..................................................................................4
Author Contact Information............................................................................................................5

ongress is considering a short run stimulus package that may include individual and
business tax cuts.
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Several types of tax cuts were partially or fully enacted for purposes of short run
economic stimulus in the recent past (2001-2003). These tax revisions were the first in some time
that were motivated, at least in part, by the need for expansionary fiscal policy. In the late 1990s,
the economy experienced a protracted period of significant growth, and, in the decade prior to
that most tax legislation addressed a need for deficit reduction (the objective of most tax change
between 1982 and 1997, as was the case in the 1990 and 1993 tax changes) or a desire for ¹
structural change (in the 1986 and 1997 tax revisions).
Very different types of stimulus provisions were enacted in the period 2001-2003: the 2001 tax
cut was aimed at individuals, but most of its provisions, especially the rate cuts, which were
phased in over a number of years, were not based on the recession that was apparent in 2000 and
that appeared in the spring of 2001. When concerns about the economy continued towards the end
of 2001 and in 2002, the Congress enacted bonus depreciation. And, in 2003, the tax provision
advanced to stimulate the economy was a reduction in dividend taxation.
In February 2008, a stimulus package containing a rebate and bonus depreciation was adopted.
This report discusses the rebate, bonus depreciation, and dividend relief as mechanisms for
stimulating the economy in the short run.

The 2001 tax cut was not primarily enacted because of concerns about a recession and most of the
provisions were phased in over a number of years. However, concerns about a slowing economy
did motivate the advance tax rebate provided in 2001. Because the tax cut was enacted close to
mid-year (in May) it was difficult to provide a tax cut for 2001 that could be reflected
appropriately in withholding. By the time withholding changes could be put into place, much of
the year would have passed and either withholding changes would be inadequate (deferring tax
cuts until returns were filed the following year), or if made larger to compensate for the partial
year effect would have resulted in a withholding increase for some taxpayers at the beginning of
2001. The rebate proposal provided for the mailing out of checks to taxpayers in the fall of 2001
that were advance reductions for the introduction of a 10% rate bracket for 2001. They were,
however, based on taxpayers’ 2000 tax returns and any excess credits did not have to be repaid
when returns for tax year 2001 were filed. (Taxpayers whose credits were smaller than those
allowed on 2001 returns, however, received additional relief when tax returns were filed). The ²
checks were mailed out between July and October.

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The rebate met some important standards for an effective tax cut stimulus.³ Unlike many stimulus
proposals in the past, particularly in the 1960s and 1970s, where the stimulus occurred during the
recovery rather than the recession phase (potentially adding to inflationary pressures), its impact ⁴
occurred during the recession. In addition, tax cuts are most effective as a stimulus if they are
spent, and the tax reductions affected lower and moderate income taxpayers who have a high
propensity to spend.
At the same time, there was some concern that lump sum payments might be spent in the same
fashions as a continued increase in income through tax reductions. There was some evidence that ⁵
temporary rebates in the past were not spent. It appears, however, that most of the rebate was
spent fairly quickly: at least 20% to 40% in the quarter received and two-thirds by the end of the ⁶
second quarter after receipt.
Studies of the 2001 rebate also point to the importance of directing the rebate to households with
low incomes and with fewer liquid assets. In the study by Johnson, Parker, and Souleles,
households with low incomes were estimated to have increased spending by more than the rebate,
while middle-income individuals spent less than 20%. Households with few liquid assets also ⁷
increased spending more. Another study found that households with lower credit card limits, or ⁸
who were near their limits, or used their credit cards intensively, increased spending the most.
The Joint Tax Committee study⁹ discusses some important administrative issues surrounding a
cash rebate.

Following the September 11, 2001, attacks, concerns once more arose about the economy. A tax
package proposal that included a business tax cut in the form of reduction in the corporate
alternative minimum tax and an acceleration of rate reductions failed to achieve passage in 2001.
In 2002, a bill was adopted and the centerpiece, as far as tax provisions were concerned, was a
temporary, two-year, provision for bonus depreciation. This provision, responding to a concern
about lagging business investment, allowed businesses to deduct 30% of the cost of most business
equipment purchases when incurred rather than depreciating them over several years (typically

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five to seven years). Bonus depreciation was increased to 50% in 2003 and extended through

2004.

Among the business tax incentives, a temporary investment subsidy should have the most “bang ¹⁰
for the buck.” By directing the subsidy at investment, the stimulus does not provide a windfall
for existing capital. By making the provision temporary there is an incentive to make investment
now rather than later. Nevertheless, a study of the effect of temporary expensing by Cohen and
Cummins at the Federal Reserve Board found little evidence that bonus depreciation was ¹¹
effective in stimulating investment. They suggest several potential reasons for a small effect.
One possibility is that firms without taxable income could not benefit from the timing advantage.
In a Treasury study, Knittel confirmed that firms did not elect bonus depreciation for about 40%
of eligible investment, and speculated that the existence of losses and loss carry-overs may have
made the investment subsidy ineffective for many firms, although there were clearly some firms ¹²
that were profitable that did not use the provision. Cohen and Cummins also suggested that the
incentive effect was quite small (largely because depreciation already occurs relatively quickly
for most equipment), reducing the user cost of capital by only about 3%, that planning periods
may be too long to adjust investment across time, and that adjustment costs outweighed the effect
of bonus depreciation. Knittel also suggests that firms may have found the provision costly to
comply with, particularly because most states did not allow bonus depreciation.
A study by House and Shapiro found a more pronounced response to bonus depreciation, given
the magnitude of the incentive, but found the overall effect on the economy was small, which in ¹³
part is due to the limited category of investment affected and the small size of the incentive.
Their differences with the Cohen and Cummins study reflect in part uncertainties about when
expectations are formed and when the incentive effects occur.
One issue that these studies do not provide insight to is the desirable length of time to allow the
temporary provision. If the time is too long, the provision is not very effective because the
stimulus may be delayed, but if it is too short firms do not have time to make adjustments.
Cohen and Cummins also report the results of several surveys of firms, where from 2/3 to over
90% of respondents indicated bonus depreciation had no effect on the timing of investment
spending.
Overall, bonus depreciation did not appear to be very effective in providing short-term economic
stimulus. It is possible, however, that a stimulus during current times, when losses are not as large
as they were in 2002-2004 when the economy was already in a recession, could be more
successful.

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The third provision that was advanced as a short term economic stimulus was an Administration
proposal to eliminate taxes on dividends in 2003. Eventually a proposal that reduced the tax rates
on dividends from ordinary rates to 15% was adopted as a temporary measure; a reduction in the
top capital gains tax rate from 20% to 15% was also adopted.
While the provision was based on grounds of boosting the stock market and stimulating the
economy, this provision would not, on theoretical grounds, be considered an effective short term
stimulus. A short run stimulus must increase spending if it is to be effective, and, for a tax
reduction, that increase must be either in consumption or investment. However, dividend tax
relief is not likely to increase consumption spending because it tends to accrue to higher income
individuals who are likely to save it. It is not an effective investment incentive because it benefits
savers, not those directly making investments, and the translation from saving to investment
would actually be contractionary in the short term. Thus, although the provision was advanced as
a short term stimulus provision it is unlikely to be as effective for this purpose as other ¹⁴¹⁵
alternatives, and the Congressional Budget Office study does not discuss it.

The February 2008 stimulus package included an individual tax rebate. Unlike the 2001 rebate,
this rebate provided for refundability for taxpayers with at least $3,000 of earnings, Social
Security benefits of veterans benefits. It also included bonus depreciation of 50% for one year.
Some preliminary evidence has been reported on the 2008 rebate. Although aggregate data do not
show a rise in consumption to correspond with the rise in disposable income, these simple
aggregate observations may not be very informative. In a preliminary study of households, Broda ¹⁶
and Parker found that 20% of the rebate was spent in the first month. They predict that the 2008
rebate will have a significant effect on spending in subsequent months. Their study also found
higher levels of spending for lower income households and those with fewer liquid assets.

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