Can taxpayers be stimulated?

How effective are household handouts in kickstarting a flagging economy? Are they a fast and effective means of boosting demand? Or are stimulus payments like taking a bucket of water from the deep end of a pool and dumping it into the shallow end (as George Mason University economist Russell Roberts has argued)?

Compared with infrastructure projects - which typically take over a year to commence construction - sending cheques to households has the virtue that it can be done in a few months. Yet there has been considerable debate in the academic literature over their efficacy. For Australians, this debate is more than an academic bunfight: if household handouts are always saved, the federal government just sent out $20 billion to no effect.

It turns out that this is one of those areas where economic theory doesn’t take us very far. At one extreme lies the “permanent income hypothesis”. This implies that when politicians say “Cash bonus this year!”, voters hear “Tax rise next year!”, and put the money in their piggybank. In its pure form, this theory implies that household stimulus has no impact on total expenditure. Indeed, if you add in the fact that raising tax revenue reduces economic activity (by dampening work incentives), it is theoretically possible that a dollar of government cash handouts reduces economic activity by 20 cents or so.

But it is possible to imagine that taxpayers might not be quite so cool and calculating. Experiments from psychology and economics have shown us that individuals tend to undervalue consumption tomorrow in favour of consumption today. Despite knowing that regular gym attendance, going on a diet, or starting a savings plan would be good in the long run, many people have difficulty starting today. Send a myopic taxpayer a few hundred dollars, and she might just spend it.

Empirically, there are three main techniques that economists use for estimating the impact of handouts on total expenditure. The first is to analyse aggregate data, trying to observe sudden changes in the month when the payments were delivered. Yet the problem is that it is extremely hard to know the counterfactual: what would the aggregate figures have looked like in the absence of the payment? Although this approach has dominated the Australian debate, it is a bit like trying to evaluate a single player by looking at whether the team makes the grand final.

The second approach to evaluating the impact of household payments is to use random variation in their timing. In the United States, stimulus payments mailed out to households in 2001 were randomly ordered according to the penultimate digit in the taxpayer’s social security number. This allowed David Johnson (US Census Bureau) and his co-authors to add a few questions to the main consumer survey in the US, and see whether early recipients spent more than late recipients. Restricting the analysis to non-durable goods, they conclude that 37 per cent of the payments were spent in the first quarter, and 69 per cent the following quarter. (A recent analysis (PDF 65KB) by Christian Broda at the University of Chicago and Jonathan Parker at Northwestern University finds similar results for the 2008 payments.)

The third strategy is to ask households what they did with their money. While economists are typically leery of using stated preference over revealed preference, such a strategy is much more straightforward to implement than the second approach. In studies of the 2001 and 2008 US payments, Matthew Shapiro and Joel Slemrod from the University of Michigan find that around 20 per cent of households report spending their tax payments, with the rest saving it or using it to pay off debt.

In Australia, similar questions record much higher spending rates. My own analysis (PDF 391KB), using data from a June 2009 poll conducted by the Australian National University, found that around 40 per cent of recipient households reported spending the stimulus payment. Since this was only based on the months immediately after the cheques were mailed out, the six-month impact on expenditure was likely to have been larger than 40 per cent. (A differently worded Westpac survey suggested that around 70 per cent was spent.)

Who spends, and who saves? Comparing Australian households, I found several statistically significant patterns. Recipients were more likely to spend the money if they were less worried about someone in their household losing their job. Those who were less concerned about government debt were also more likely to be spenders. But perhaps the most curious pattern was that - even holding constant demographics such as age and income - Labor voters were more likely to spend than Coalition voters.

On face value, a government that levies taxes so it can send cheques to the voters hardly looks a paragon of fiscal rectitude. But for the US and Australia, the evidence suggests that one-off payments can play an important role in cushioning the worst effects of a downturn.