A Smarter Stimulus.(The Talk of the Town)(economic stimulus plan)

Cutting taxes is usually a surefire political winner. Yet Barack Obama's plan to include more than a hundred billion dollars in individual tax rebates in his stimulus package has earned him criticism from both ends of the political spectrum. Critics in his own party think the rebate, which Obama wants to distribute by reducing people's withholding payments, will be too small to make a difference--the equivalent of an extra forty dollars or so a month. Naysayers from the right maintain that, because the tax rebate is a onetime event rather than a permanent reduction in tax rates, it will have only a negligible effect. Skeptics on both sides worry that most people will save the rebate rather than spend it.

The criticism isn't unwarranted. The record of past tax rebates is checkered, and forty bucks a month doesn't sound like much. But the very things that seem unusual about Obama's rebate plan--that it will be handed out by reducing withholding, instead of in one lump sum, and that it will add a small but steady amount to Americans' take-home pay--are precisely why it's more likely to succeed.

Past tax rebates, as many economists have argued in recent weeks, haven't seemed to boost consumption as much as was hoped. Some estimates suggest that when a rebate was handed out in 2001 less than half of it was spent. And while the results of last year's rebate seem to have been somewhat more encouraging, much of it still went unspent. One explanation for why rebates don't have a bigger impact is that they don't affect what Milton Friedman called people's "permanent income." Friedman argued that people's spending is determined by what they think their income will be over time: they change their spending habits only if they think they're going to be permanently wealthier or poorer.

The permanent-income hypothesis is elegant, but studies have shown that it's not always an accurate description of the way people decide how to spend and save. A more compelling explanation for why rebates haven't worked very well is that they have been handed out as lump sums. You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn't, because people don't treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different "mental accounts," which in turn influences what they do with the money. Where the money comes from can have a big impact on whether people spend it or save it: casino winnings are more likely to be spent than, say, money from an inheritance. The framing of a windfall is important, too: a recent study by the business professors Nicholas Epley and Ayelet Gneezy showed that when a tax rebate was presented as a bonus it was more likely to be spent than ...