Thursday, December 16, 2010

Rich vs Poor Relative Marginal Consumption under Deleveraging

A number of people have made the argument that the tax cut isn't really as stimulatory as it could be because rich people save too much of their income, so they shouldn't get the tax cut.

The problem with this argument is that we're currently in a period of deleveraging, and marginal savings rate is what matters when you have a tax cut.

Peter Poorman may make little money; say, $25,000 a year (We'll ignore the substantial aid programs that exist that would boost his salary substantially - like, double). He's in debt. He's trying to pay it off, slowly, after incurring it over the last few years. His savings rate has risen from negative 2% to positive 3%, and he's adjusted his lifestyle to fit the 4.9% budget reduction (spending 102% of his income to spending 97% of his income means a 4.9% reduction in his budget).

Rodney Richman may make more money - say, $250,000 a year, and have no debt. He's able to save 20% of his income!

Clearly, Rodney's savings rate is much higher than Peter's; the economy would be better off if Rodney would spend like Peter.

The problem, of course, is that this is an average effect, and a tax cut happens on the margin.

If you gave Peter an extra $100, some of the money is going to go to alleviating the budget reduction, but, importantly, he's ALREADY SET A GOAL OF REDUCING HIS DEBT BURDEN. It's quite plausible that he'd use $25 to alleviate the budget reduction, and $75 to hit the debt that he knows he needs to get.

Rodney's behavior's a little more challenging, but not much more so. Rodney is not likely to exhibit the behavior "Save 0% up to $200,000 and 100% after that!" His savings on the margin will be higher than his average - as should always be the case for everyone, regardless of income level - but it's actually quite likely that he ends up saving 50% and spending 50%, just like Peter.

50/50 and 25/75 are arbitrary numbers; I don't know what the real ones are. But based on the psychology of debt consumption and an understanding of marginal utility of income, it is very likely that on the margin, tax cuts for the rich are more economically stimulatory than tax cuts for the poor IN AN ENVIRONMENT OF DELEVERAGING. The conventional (read: "during leveraging") wisdom about savings for rich vs poor gets thrown out the window when you're in an environment where the poor are deleveraging.

No comments:

Post a Comment