What to do about tax cuts

Posted: Mar 28, 2001 12:00 AM
In recent days, a consensus appears to have developed in the Senate on the idea that there should be at least a $60 billion tax cut this year. This would be considerably more than George W. Bush originally proposed, but he has signaled a willingness to support speeding-up his tax plan. The problem is that many Democrats do not see this as a speeding-up of Bush's proposed tax-rate reduction, but rather as a substitute for it. The Democrat argument is that money needs to be put into consumers' pockets as soon as possible to reverse the economic slowdown. The theory is that since consumption is about two-thirds of the gross domestic product, then making it easier for consumers to spend will give the economy a boost. Democrats say, therefore, that some sort of tax rebate that will inject cash into the economy quickly is better than the slowly phased-in tax rate reductions proposed by Bush. The Democrat argument has superficial appeal. The problem is that we did exactly what Democrats are proposing 26 years ago and it had no impact on the economy. In 1975, Republican President Gerald Ford was presented with exactly the same options that the Congress is now considering: a one-shot tax rebate or a permanent tax-rate reduction. With overwhelming Democratic majorities in both the House and Senate in the wake of the 1974 elections, Ford chose the tax rebate option. He believed it was better to do something quickly, even if it was the less desirable option, than fight a drawn-out battle over rate reductions. The Tax Reduction Act of 1975 was signed into law on March 29 in the midst of the deepest recession in postwar history. Taxpayers received a 10 percent "refund" on their 1974 taxes, with a minimum of $100 and a maximum of $200. Checks were mailed out in the second quarter of 1975. This added about $8 billion to disposable income -- close to the $60 billion being proposed now in today's dollars. The problem is that most people didn't immediately go out and spend the money, as predicted, and thus there really was very little economic stimulus. In fact, what people tended to do with their windfall was either save it or use it to pay down debt, which is the same thing. This result was perfectly predictable by anyone familiar with an important economic theory developed by Milton Friedman in the 1950s called the "permanent income hypothesis." He studied consumer behavior and found that consumption didn't automatically go up and down with disposable income. People tend to spend according to what they believe their permanent income is. Hence, when they got a temporary income increase, they saved it. Conversely, if they suffered a temporary reduction of income, such as through a job loss, they borrowed to maintain their consumption at the same level. Friedman observed that only when consumers got what they considered a permanent income rise, such as through a job promotion, did they raise their consumption. It follows from this that only permanent tax cuts, which permanently raise disposable income, will have any meaningful impact on consumption. This insight is one of the reasons why Friedman was awarded the Nobel Prize in economics in 1976. Subsequently, a number of studies looked back at the 1975 tax-rebate experience to see what effect it actually had. In general, they find that the permanent income hypothesis was correct in predicting little change in spending, and hence growth, from the rebate. The first study was done by Franco Modigliani (another Nobel Prize winner) and Charles Steindel for the Brookings Institution in 1977. Using several large computer models of the U.S. economy, they estimated what consumption would have been with and without the rebate. Their conclusion was that no more than one-fourth of the rebate was spent in the first three quarters after it took effect. Moreover, they could not reject the possibility that none of the rebate was spent. "We conclude," they wrote, "that there is strong, though not uniform, evidence that a rebate is not a particularly effective way of producing a prompt and temporary stimulus to consumption." The second study was done in 1981 by economist Alan Blinder, who was later appointed by Bill Clinton to the Council of Economic Advisers and the Federal Reserve Board. Looking at both the 1968 tax surcharge, a temporary tax increase, and the 1975 rebate, Blinder concluded that temporary tax changes have less than half the impact of a similar-sized permanent tax change. Furthermore, rebates were even less stimulative than other temporary tax changes, delivering just 38 percent of the impact of a permanent tax cut. The negative experience of the 1975 rebate ultimately was critical in changing the terms of debate on tax policy. Afterward, the idea of fine-tuning the economy through temporary tax changes fell out of favor and the idea of stimulating growth through permanent tax-rate reductions gained popularity. By 1978, a Democratic president (Jimmy Carter) and a Democratic Congress even enacted a major reduction in the capital gains tax, because they recognized that encouraging investment was a better way to increase growth than subsidizing consumption. The obvious lesson is that a tax rebate now is just as bad an idea as it was in 1975. It will not stimulate consumption and will not boost growth, because the permanent income hypothesis has not been repealed. Only permanent tax rate reductions, such as those proposed by Bush, will actually raise consumption and growth. It follows from this that any kind of trigger mechanism on the tax cut is counterproductive. That would transform any supposedly permanent tax cut into a temporary one, thus sharply reducing its stimulative impact on the economy. This may sound like ancient history, but many key government officials today remember it well. Vice President Dick Cheney was Ford's chief of staff, Federal Reserve Chairman Alan Greenspan was his Council of Economic Advisers chairman, and Treasury Secretary Paul O'Neill was deputy director of the Office of Management and Budget. So even if no one else in Washington remembers that tax rebates are not stimulative, they do. They should make sure that those in Congress know, too.