Just before Christmas the House passed the Senate's two-month extension of the payroll-tax holiday, raising workers' paychecks by two percent for the next two months. Republicans in the House initially objected to the measure, insisting that the extension, if there must be one, should be for a full year rather than having another showdown in just two months. Republicans also argued that if saving Social Security was really a concern of Democrats, then it doesn't make any sense to divert funds away from Social Security in the first place.
From an economic perspective, the Republicans were correct, even if they came out losers from a political perspective. Tax cuts that are permanent work much better than temporary tax cuts.
Traditional Keynesian economics posits that when consumers receive higher income in the form of a tax cut, they save a fraction of it but spend the rest. That additional spending further stimulates the economy, providing a multiplier effect. For example, Mark Zandi's model suggests that temporary tax cuts boost the economy by $1.29 in the first year for each $1 in cuts (see Table 3 here). On the other hand, permanent tax cuts only increase GDP by about $0.51 in the first year for each $1 in cuts according to his model.
However, the evidence on temporary tax cuts is much less supportive than large-scale macro models suggest. A recent paper by Sahm, Shapiro, and Slemrod (here) uses survey response data based on the Consumer Expenditure Survey and the University of Michigan Survey of Consumers to examine the responses to the 2008 lump-sum stimulus payment and the 2009 temporary tax cuts; and it reviews similar survey research done after the 2001 lump-sum tax credit and 2003 tax cut. Quoting from their conclusion (p. 29), "All in all, none of the policies implemented in 2008 and 2009 to increase disposable income was very effective on a per-dollar basis in stimulating spending in the near term." They do point out that the effectiveness of temporary tax policy changes does depend on the economic environment, consumers' balance sheets (how indebted they are), and how the stimuli are distributed (one-time payments versus changes in withholding). Nevertheless, the evidence suggests that temporary tax cuts do not work well.
Milton Friedman's Permanent Income hypothesis, lifecycle models like those of Peter Diamond, and the concept of consumption smoothing all help to explain the discrepancy. Basically, all these ideas boil down to the idea that consumers like to maintain a constant level of consumption over time. Most people prefer not to live in a mansion one year and a mobile home the next year; they try to maintain a similar lifestyle over time. Thus, a temporary tax cut will not cause them to go out and spend a lot more. Instead, they may spend a small portion of the tax cut, but for the most part they will just save the money, rather than have a volatile stream of consumption. On the other hand, a permanent tax cut, by definition, implies that income will be higher for all future periods than it would have been prior to the cut. Therefore, the household can increase consumption and maintain that higher level of consumption over time -- they won't need to reduce consumption again as they would if the tax cut were temporary.
Keynesian models are not very good at incorporating peoples' beliefs about their future income, and that's why these models overstate the impacts of temporary tax cuts.
Of course, some consumers are constrained by debt or else already struggling to get by. Those consumers would be more likely to spend whatever additional income they receive. But in my opinion it is hard to believe that there are enough of those consumers to outweigh the effects of consumers who tend to smooth consumption and income over time.
So temporary tax cuts don't appear to have much impact. Permanent tax cuts that affect consumers' behavior, as well as the behavior of investors, entrepreneurs, etc., are much more capable of boosting economic growth.
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