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See Inside November 2011

Low Taxes, High Rhetoric: What Consumers Really Do with Their Tax Cuts

The Republican-Democratic debate over income tax rates and the size of government has been long on rhetoric but short on data. What does published research say about what different economic groups do with savings from income-tax cuts? Will the economy slow if Washington cancels tax cuts on millionaires and billionaires?

Most experts agree that tax cuts can stimulate a weak economy over the short term through increased consumption and investment, provided the money flows to people who are more likely to spend than save. Past observation has shown that because lower-income people often live paycheck to paycheck, they are more likely than the wealthy to spend. Yet “our research suggests that hasn’t been true for the past decade,” says economist Joel Slemrod of the University of Michigan at Ann Arbor. Because the last few tax cuts have followed financial crises, poorer people may have used the extra income to increase their cushion by building up assets or paying down debt. But the rich haven’t been spending freely either. Last year a study by Moody’s Analytics suggested that the 2001 and 2003 tax cuts spurred the wealthy to significantly increase their savings as well.

What should the administration do to design a better economic shot in the arm? One finding on which researchers seem to agree is that consumers respond more vigorously to policies thought to be long-lasting. Therefore, Slemrod says, one farsighted action may plausibly help the economy: convincing the general public that the federal government is committed to getting its fiscal house in order.

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