On the Economic Stimulus Package: The "Packaging" Counts

To get people to spend more, reduce payroll tax, not income tax.

Posted Feb 01, 2009

As the U.S. Senate prepares to debate President Obama's $800 billion stimulus package, there is broad agreement about three things: we must create jobs to compensate for rapidly growing unemployment; we must put money in people's pockets so that they will start spending again; and we must do whatever we do so that it works fast. But when it gets to specifics, the agreement seems to end. How many jobs will this or that initiative create, and how fast will it create them? How much will people spend if they get a tax rebate, and how much will they put in a mattress as a hedge against uncertain times? Some of the debate is just politics, but a lot of it reflects real disagreement and uncertainty as the nation wanders through unfamiliar territory without a roadmap.

In this article, I want to focus on the possible benefits of tax rebates, and suggest that behavioral economics has something to teach us-not about whether to provide them, but about how to provide them if we do.

It seems obvious that if you want and need people to spend money, the most direct way to achieve this result is by giving them money to spend. And it seems obvious that the most direct way to give people money to spend is by refunding some of their taxes. But when President Bush did this not long ago, people didn't spend. Estimates are that more than 50% of the rebates taxpayers got went into savings, or to pay down debt. So as the Senate contemplates several hundred billion dollars worth of tax relief, there is skepticism about how effective it will be in stimulating the economy.

Behavioral economics suggests that whereas it is certainly important what is in a package, it is also important how the package is wrapped. What do I mean? Economist Richard Thaler made a major contribution by pointing out that people organize their finances into what he called "mental accounts." Instead of having one gigantic balance sheet, with assets on one side and liabilities on the other, we divide our financial lives into categories. To take a personal example, my wife and I recently had the second floor of our house remodeled. It was a large, time-consuming, and costly operation. One piece of the remodel was a new bathroom. As we deliberated about fixtures for the bathroom sink, we saw some lovely ones that were outrageously expensive.

If all we were doing was replacing the fixtures in our bathroom sink, we wouldn't have given them a moment's thought. But we weren't. The fixtures were a small part of a very large expense. What difference would an extra $500 make in the grand scheme of things when it was part of a renovation that cost thousands? Sanity eventually prevailed, but it is amazing that we were even tempted by these high-end fixtures. Such is the power of mental accounting. Considered in isolation, the high-end fixtures were ridiculous. Considered as part of a much larger mental account, they were live candidates.

The same sort of thing happens when it comes to deciding whether or not to add high-priced options when you're buying a new car. You'd never spend $1000 on Walnut trim by itself, but when it's part of a $30,000 purchase, well, maybe you would. Thaler points out that one of the ways in which the replacement of cash with plastic (credit cards) has induced people to spend more than they should is that when we use our credit cards, it doesn't feel like we're spending money until the bill comes. And when the bill does come, the item in question is just one of a long string of expenditures. How different would your financial circumstances have been if you hadn't bought that luxurious sweater?

We can apply the lessons of mental accounting to the stimulus package. Perhaps a major reason why the Bush tax rebate failed to stimulate spending was that it came as a lump sum. Paid all at once, a rebate of $500 is real money. Yesterday you didn't have it, today you do. This substantial windfall might cause you to stop and think about what to do with the money. And when people stop and think, at least sometimes, they choose not to spend. But suppose, instead, it had been paid as a $10/week addition to your regular paycheck? Then, it would hardly be noticeable. One more latte at Starbucks. Steak instead of chicken at the restaurant. The ten bucks would just get absorbed into your weekly wage. You'd live a little better, and your money would go a little further, without you giving it a moment's thought.

What this implies is that if the stimulus package includes tax relief, and if we want people to spend the money they get, we should make sure that the money comes in "spendable" packages. Not as a lump sum, but as dribs and drabs. One simple way to achieve this result in practice is by providing the tax relief in the form of a payroll tax (social security tax) "holiday." Instead of having that 7.65% deducted every week, it just gets added to your paycheck. The worker who takes home $600 week now finds an additional $45 in her pay envelope. That's money that is much more likely to be spent than a one-time, lump-sum payment.

A payroll tax holiday has other advantages. The payroll tax is the most regressive tax we have, and a holiday will undo some of that damage, even if only temporarily. In addition, it may be good politics. Some legislators object to aspects of tax rebate proposals on the table, because these proposals will include sending checks to people who earn too little actually to pay any income tax. True, these are the people who need help the most, and who are most likely to spend the money, but it strikes some as unfair to "refund" taxes that people haven't paid. But everyone pays the payroll tax.

These issues aside, the payroll tax holiday is probably the most effective way to put money in people's hands that will be spent, not saved. Even if the stimulus plan does end up with income tax rebates, attention should be paid to providing these rebates in installments, to make them more "spendable" and less "saveable."

Some may object to engineering the stimulus plan in a way that manipulates people's behavior. It seems somehow disrespectful-even underhanded. In response to that concern, I just want to point out that every incentive, of any kind, is an effort to manipulate. Yet, incentives are the American way. As Thaler and his collaborator Cass Sunstein argue in their book, Nudge, every policy decision we make pushes people in one direction or another. In that light, we should take some pains to make sure that the nudges we provide in the stimulus package are nudges in the right direction.