As we ponder the compromise that will keep the Bush tax cuts going in exchange for extended unemployment benefits, let's keep a couple of things in mind.
1. The Bush tax cuts are still slated to expire. Per Friedman's permanent income hypothesis, income expected to be temporary is less likely to be spent than when income is expected to be permanent. The temporary nature of the tax cut also stymies investment spending since future cash flows from an investment are more uncertain with a temporary tax cut. The bigger my forecast error on my future tax payments, the less likely I am to invest. It also keeps employment lower than if the tax cuts were made permanent. Congress could have done the country better by extending them indefinitely.
2. On purely positive grounds, extended unemployment benefits provide an incentive for people to remain unemployed.
Update: Doc's take:
- cut taxes and increase transfer payments to increase aggregate demand and reduce unemployment (to move the economy up and leftward along a given short-run Phillips curve). Both John Lott and Phil are skeptical about the efficacy of this policy.
- at the same time keep in place policies that encourage unemployed persons to search longer, thus shifting the long-run Phillips curve to the right.
This combination is same as the one we experienced in the late 1960s and early 1970s. If the policy trends continue, I'm guessing the US could very well be in for another bout of Stagflation in the next year or two.
If Doc's right, then the best we'll have as economists is a contemporary example of what's wrong with practical Keynsianism.
