Explain why it makes a difference if consumers consider a tax cut temporary rather than permanent. What does this explanation tell us about the importance of government credibility? Put this in the context of the 2008 and 2009 tax cuts favored by President Bush and President Obama.

Question

What will be an ideal response?

Answer 1

Consumers tend to base their spending decisions on their expectations of long-run income. Short-term or one-time-only income changes have little effect on consumer behavior. If tax cuts are perceived as only temporary, then consumers will use less of the additional disposable income for spending on goods and services and may use a major portion of the temporary income increase for saving. Tax cuts that are perceived as permanent will change consumers’ expectations regarding their future income more significantly. This change in expected future income will make consumers feel more comfortable about increasing their current spending. If government policy makers wish to increase aggregate demand by cutting taxes and they hope the tax cut will significantly increase consumer spending, then the public will have to believe that the government’s pledge to leave the tax cut in place is honest. If the public mistrusts the government and believes a current tax cut may soon be cancelled or reversed, then consumers may not change their spending habits in any significant way. This mistrust will render tax policy ineffective and remove a powerful tool from those available to a government. In 2008 and 2009, taxpayers concluded that the tax cuts were only temporary and not permanent. Because they felt the tax cuts were only temporary, they did not have the stimulative effect on aggregate demand that the administrations were hoping for.