It now appears increasingly likely that some sort of tax rebate will be enacted this year to cushion the impact of a slowing economy. The problem is that rebates don't work and never have. There are, however, effective short-term measures that could be taken to stimulate growth. Unfortunately, they are not on the agenda for discussion at present.
One problem with the rebate idea is that it is aimed at pumping up disposable income, and thereby stimulating consumption. But last Friday's reports on the gross domestic product and personal income from the Commerce Department show clearly that the economy's problem is not falling income and consumption, but falling investment.
In the fourth quarter of last year, real GDP grew just 1 percent. But consumption was up 2.8 percent. The major factor causing the slowdown in growth was a sharp drop of 4.1 percent in gross domestic investment. By contrast, in the second quarter of 2000, investment rose at a 21.7 percent annual rate. Going from plus 21.7 to minus 4.1 in the space of three quarters is a remarkable turnaround that largely explains the overall economic slowdown.
The personal income report for February confirms that personal income and consumption are still growing at a healthy rate. In the first two months of 2001, when the economic slowdown really began to hit, personal income was up at a 5.4 percent annual rate -- the same rate of growth as in all of 1999, when the economy was clearly much stronger. Personal consumption expenditures were also strong, rising at a comfortable 7.8 percent annual rate.
Thus the evidence supporting the need for a quick shot of stimulus to income and consumption simply is nonexistent. Yet, this has not dampened support for a quickie tax rebate. Over the weekend, Washington Post columnist David Broder again promoted the idea. And even the normally sensible Fred Barnes, writing in the conservative Weekly Standard, now calls a rebate "the boldest step" that George W. Bush could take.
The truth is that even if there were evidence supporting the idea that falling income and consumption were the cause of the economy's ills, history shows that rebates just don't work. A 1992 study by the Congressional Research Service explains why.
-- Even if Congress works at breakneck speed, money from a rebate will not begin to flow until the economy is well past the worst of the downturn. If the rebate takes effect during the upturn, it could rekindle fears of inflation. Even if such fears are unjustified, they could cause the Federal Reserve to stop easing monetary policy.
-- A permanent tax cut has more stimulus, even in the short run, than a rebate. "In the first year, a rebate probably has no more than half the stimulative effect of a permanent tax reduction of comparable magnitude," according to the CRS.
This analysis suggests two things. First, from the point of view of consumers, Bush's permanent tax-rate reduction is actually better for short-term stimulus than a one-shot tax rebate. Second, if additional short-term stimulus is still needed, it would be better to stimulate investment, rather than consumption.
On the latter point, one way to go would be to rejuvenate the Investment Tax Credit, first instituted by John F. Kennedy in 1962 and repealed in 1986. Over the years, the ITC was Congress' first line of defense against an economic slowdown because it can be turned on and off relatively easily.
The ITC gave businesses a credit against their corporate tax liability of 7 percent of any new investment in machinery or equipment. Thus, if a firm invested $1 million in new machinery, it deducted $70,000 directly from its tax payments. And because checks don't need to be sent out before businesses react to the credit, its impact is instantaneous. Businesses always have investment plans prepared and will move swiftly to implement them once the ITC is available.
Historically, the stimulus effect of the ITC was enhanced by its temporary nature. Congress suspended it in 1966, reinstated it in 1967, suspended it again in 1969 and put it back on in 1971. In 1975, in the midst of our deepest postwar recession, the ITC was increased to 10 percent. Thus, if a company wanted to get the benefits of the ITC, it had to act quickly.
In permanently repealing the ITC in 1986, Congress felt that it tended to bias investment decisions in favor of equipment and against other forms of capital. Also, the credit was of no value to firms with losses and therefore no tax liability. This was especially a problem for new startups, which often need years to start making profits. This led money-losing companies to enter into complex leasing arrangements for equipment, which were often viewed as nothing but tax shelters, so that the value of the ITC could be captured by someone who could use it.
These are still valid criticisms. For this reason, it would be better to stimulate investment by shortening depreciation, the write-off firms get for the wearing-out of their equipment. But implementing such a tax change will probably take too much time to make it effective for short-run stimulus. For that, the ITC would probably work better.
Obviously, Bush is not about to change his proposal at this date. But for Democrats looking for an effective counter to it, an investment-based alternative makes much more sense than a discredited rebate. Indeed, it is Democrats that historically have been the ITC's biggest supporters, since it rewards actual investment that goes directly into GDP growth.
Supporting a new ITC would also be clever politics for the Democrats, because it would quickly split the business community, which has little riding on passage of a tax cut aimed only at individuals. There has been considerable grumbling in corporate suites about the lack of tax cuts for business in the Bush package. Many would quickly jump on board the ITC if it became a viable alternative.
Over the weekend, Sen. Joe Lieberman, Connecticut Democrat, opened the door to an investment-based Democratic tax plan by endorsing a cut in the capital gains tax. Adding something for businesses to it would create a very potent alternative, both economically and politically, to the Bush plan.