How Do Tax Changes Affect Spending?

BY Paul Solman  November 21, 2011 at 1:49 PM EDT

Customers ride down an escalator with shopping bags at a Macy's Inc. store in New York.

Paul Solman frequently answers questions from NewsHour viewers and readers on business and economic news on his Making Sen$e page. Here’s Monday’s query:

Name: Aime Casavant

Making Sense

Question: How does raising or lowering taxes affect the economy? What difference does it make if the government spends the money on tanks, infrastructure, buildings or if the people spend it on 42″ TV screens, cars, home improvements. Since the money is spent, someone has a job making these things and then spends the money they make on other things. I don’t get it. What difference does it make?

Paul Solman: Because people don’t spend all their money. They save some of it. People with more money tend to save more; people with less, to spend more. So if you lower taxes on people who spend more — the less well-off, that is — you get more spending. If you lower them on the proverbial “1 percent,” you get more saving.

But wait, you might ask: Why isn’t saving just as good as spending? Since the money has to be saved somewhere — a bank, say — unless it’s been tucked under a mattress? And presuming the bank doesn’t resort to mattress-tucking either, then it will lend the money out to someone who will spend? So, you might also ask, what’s the difference? Ultimately, the money simply recirculates, no?

(The envelope, please.)

Reading aloud: “The answer is: No.” To elaborate, saved money does not simply recirculate into spending. It can get stuck. Not literally under a mattress, of course. But today’s functional equivalent of what used to be called “hoarding” is money in banks, on account at the Federal Reserve. I’ve explained this again and again over the past few years. The Fed is paying financial institutions — 0.25 percent in annual interest — to redeposit money with the Fed. And there it sits at this very moment — some $1.6 trillion. That’s the bulk of the famous “money on the sidelines” — corporate profits deposited with financial institutions, who, instead of loaning out the money to companies and consumers, have in turn deposited that money at the Fed.

To return to your question, Aime Casavant: If there’s too little spending in the economy — by consumers, businesses or both — then one policy would be to encourage more of it. A tax cut for those less likely to save would then be preferable to a tax cut for savers or, in the current situation, businesses.

Photo at top of Macy’s shoppers in New York by Stephen Yang/Bloomberg via Getty Images.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions _Follow Paul on Twitter._