Actually an article in the SMH from Ross Gittins - interesting reading!!! Hey, Joe: how to be better than Bishop Ross Gittins February 21, 2009 If Joe Hockey, the new shadow treasurer, is to avoid the gaffes made by his predecessor, Julie Bishop, he faces a steep learning curve. So let me help out - here's your first tutorial, Joe. Most newspapers have published articles lately by economists casting doubt on the ability of governments to improve matters during economic downturns by attempting to use tax cuts or spending increases to stimulate their economies. It's important to understand that this is very much a minority opinion among economists. Greg Mankiw, a professor of economics at Harvard, reminds us on his blog that, according to various polls of the profession in America, 90 per cent of economists believe that budget measures have a significantly stimulative impact on an economy that's less than fully employed. Further, 85 per cent of the surveyed economists believe that if the federal budget is to be balanced, this should be done over the business cycle, not every year. In other words, they accept that it's OK for budgets to go into deficit during and in the aftermath of recessions, provided they return to surplus as the economy recovers so that, over the full cycle, the deficits and the surpluses roughly cancel out. This should come as no surprise to you, Joe, because it was incorporated in the Howard government's "medium-term fiscal strategy" to "maintain budget balance, on average, over the course of the economic cycle". The Rudd Government's strategy is essentially the same. Both governments' strategies are designed to accommodate the reality that the "stabilisers" built into the budget push it into deficit automatically during recessions, then push it into surplus automatically during the expansion phase. The strategies are also designed to permit governments to add their own discretionary stimulus during downturns, provided they take steps to withdraw that stimulus once the economy is back on its feet. Next is the question of the form the fiscal stimulus should take. Although the Bush administration twice resorted to cash grants - in 2001 and again last year - the Republicans in America and the Opposition here have argued that people are more likely to spend money from a "permanent" tax cut than from a once-only cash splash. They quote the opinion of a Stanford economics professor, John Taylor, in support. Taylor is highly regarded, though his role as an adviser to the Bush administration may have impaired his academic independence. The idea that "permanent" tax cuts are more stimulatory than one-off grants rests on a theory developed by Milton Friedman, the "permanent income hypothesis". The theory is about how people decide how much of their income to spend on consumption. It assumes their objective is to smooth their income over their lifetimes, so the key determinant of how much they spend at any time is their perception of their average income over their lifetimes, called their permanent income. Since they know any temporary income coming their way - including windfalls such as a cash grant - doesn't affect their permanent income, they're more likely to save it rather than spend it. Only a lasting tax cut could be expected to raise their expected permanent income and thus induce them to increase their spending. The permanent income hypothesis is widely accepted by economists, but it's a weak argument in this context. The first and most conventional objection is the widely acknowledged existence of people who are "liquidity constrained" - who can't borrow as much as they'd like to because the banks regard them as a bad risk. In the early part of their working lives people's permanent income is likely to exceed their current income. The theory says that, in order to smooth their consumption spending over their lives, such people will borrow now to boost their consumption, paying back their debts during the period of their lives when their current income is higher than their permanent income. Clearly, people who are liquidity constrained can't pursue this strategy, so the theory implies they will spend any temporary jump in their income because this will help them with their smoothing. (Note in passing the implication that economists approve of borrowing as a way of smoothing spending. Note, too, that the running of budget deficits in bad times and surpluses in good times involves trying to smooth the nation's spending over time.) So this is a significant weakness in the theory. The Rudd Government's first cash splash in December was aimed directly at the liquidity constrained and a fair bit of its second splash will go to people who can't borrow as much as they'd like to. The next problem is that, by definition, permanent tax cuts aren't an appropriate tool to use for temporary fiscal stimulus because they permanently worsen the budget balance. Eventually they have to be reversed by "permanent" tax increases. If so, who would imagine a "permanent" tax cut delivered during a recession would have any effect on their permanent income? Next problem is that the Opposition's preferred alternative to the once-only cash grants was to bring forward to last January the permanent tax cuts already planned for this July and next. Trouble is, this itself would be a temporary move. So far we've studied the permanent income hypothesis at a quite theoretical level. I'm no believer in the theory because I don't think it stacks up empirically. It's not a convincing explanation of how the world actually works. For a start, anyone who believes any tax cut is permanent hasn't heard of bracket creep. All tax cuts gradually erode away in a tax system where the tax scale isn't annually indexed for inflation. More significantly, like all conventional economics it assumes people act rationally at all times. But a wealth of evidence from behavioural economics says people aren't rational in their decision making and, in particular, have terrible trouble exercising the self-control the theory assumes. The hypothesis implies people cut their rate of saving during downturns to make up for any temporary fall in their incomes. But this time the household saving rate is increasing and is likely to keep increasing because the looming rise in unemployment is making people worry about their high debt levels. (Paying off debts is a form of saving.) So, yes, there is a risk that a high proportion of the cash bonus will be saved. Even so, a survey of American empirical studies - including studies of Bush's two cash grants - concludes that between 20 per cent and 50 per cent of grants are spent during the first quarter, with more in subsequent quarters. Hope that helps, Joe.