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Tax cuts may heighten deflation risks - NY Fed study

NEW YORK, Feb 18 (Reuters) - Cutting taxes to try to stimulate the economy could do more harm than good in a zero interest rate environment as it can heighten the risk of deflation, according to a recent New York Federal Reserve study.

Policies that are aimed at increasing the supply of goods can be counterproductive when the main problem is insufficient demand, New York Fed economist Gauti Eggertsson said in a research paper entitled “Can tax cuts deepen the recession?”

“The emphasis should be on policies that stimulate spending,” Eggertsson said, adding that his research found the impact of tax cuts is “fundamentally different” with interest rates near zero.

“At zero short-term nominal interest rates, tax cuts reduce output in a standard New Keynesian (economic) model. They do so because they increase deflationary pressure,” he wrote. Eggertsson’s study focused primarily on labor taxes and some sales taxes.

Cutting payroll taxes, for example, would create an incentive for people to work more. But if there are not enough jobs, this could have a negative effect: creating more demand for work and thus driving down wages.

And with interest rates near zero, the Fed cannot cut rates further to fight deflation.

President Barack Obama on Tuesday signed into law a $787 billion package of measures to lift the recession-mired U.S. economy that included about $287 billion in tax cuts.

Eggertsson’s findings counter the argument that cutting taxes to put an extra buck in consumers’ pockets will boost their spending. Instead, given the current economic backdrop, it is likely people would save money from temporary tax cuts, given the recession and expectations that tax increases are inevitable in the future.

He said that while a number of economists have argued that aggressive tax cuts are needed to revive the U.S. economy, policy-makers should “view with a great deal of skepticism” studies that use post World War Two data -- a period characterized by positive interest rates.

The best ways to stimulate spending, according to Eggertsson’s study, is through traditional government spending and a credible commitment to boosting inflation, creating an incentive to spend now before prices rise. (Reporting by Kristina Cooke; Editing by Diane Craft)