Before I talk about this, I should mention that I am not very knowledgeable about macroeconomics, and this idea may be old.

My friend Nick came up with, what seems to me, an extremely good stimulus mechanism for economic downturns. When economic downturns hit, instead of providing tax refunds, states temporarily cut their sales tax significantly.

The advantage that a sales tax holiday has over an income tax breaks is that sales taxes are consumption taxes, not income taxes. When people get a break in their income taxes, it is rational for them to save the extra income in order to spread the increased consumption out over a longer period. However, when people get a consumption tax holiday, it is rational for them to move future consumption into the present, as well as move the purchase of storable goods into the present. Thus a sales/consumption tax holiday would provide more concentrated stimulus than an income tax break.

A sales tax holiday would be broad based because it would apply to all transactions which are subject to sales tax. I don’t know much about stimulus economics, but this seems desirable as it is in tax economics.

Another advantage of a sales tax holiday is that it would be easy to make automatic, which is important for a stimulus mechanism, because special stimulus plans can take time to move through legislatures. I see two ways using a sales tax holiday as a stimulus mechanism could be automated:

  1. Tie the activation of the sales tax holiday directly to local macroeconomic conditions. For example, the sales tax holiday could be triggered if the unemployment rate falls below some critical threshhold (it could also be graduated).
  2. Tie the activation of the sales tax holiday to a Normative Prediction Market, that predicts what a specific council will, in the future, say should have happened right now (i.e. “There should have been a stimulus in August of 2008”). The committee would be a lot like the current committee that dates recessions, except that it would decide whether a stimulus was a good idea. You could alternatively simply use the committee for dating recessions; InTrade already has similar markets. The sales tax holiday would be whatever the market expectation value is for the recommendation, or when the probability of recession rises above some cutoff like 30%.

A number of states already have regular sales tax holidays, though these seem to me like a bad idea, since it is undoubtable distortionary. Some other people have also suggested using a sale tax holiday, notably the Missouri Lt. Governer called for such a simulus, and some states have extended their regular sales tax holidays.

Update: The Washington Post has noted that regular holidays have provided such a stimulus, though the holiday only applies to certain goods (link).