Don't waste your mandate

Posted: Nov 21, 2002 12:00 AM
The Bush administration is presently thinking long and hard about what tax initiatives it may put forward next year. The political climate for pressing its agenda has improved with a Republican takeover of the Senate, along with retention of control in the House of Representatives. Unfortunately, there are signs that the Bush administration may waste this opportunity by pressing failed policies. In particular, there are indications that the administration may be thinking seriously about another tax rebate. It feels pressured to do something that will have the quickest possible impact on the economy. However, while rebates may satisfy the need to "do something," in fact they will accomplish nothing economically. The theory of rebates is based on Keynesian economics. Economist John Maynard Keynes argued that spending is all that matters for the economy. It makes no difference what the money is spent on, as long as it is spent. He even suggested government programs to build pyramids or paying some people to dig holes in the ground and others to fill them as ways of getting money into the economy. Keynes viewed saving as evil. In his view, putting money into a savings account was little better than burying it under a mattress. One might as well use $100 bills to start fires with as save them, in his analysis. In the midst of the Great Depression, when Keynes first put forward his ideas, there was some plausibility to them. But today, they are just nonsense. Unfortunately, many economists are still living in the 1930s, figuratively speaking. One constantly reads in the press about how such-and-such an initiative will have no impact on economic growth because it does not stimulate spending. In truth, Keynesian economics has been hijacked by the income redistribution crowd. They don't really care about what will genuinely contribute to economic growth, they just want another excuse to create new quasi-welfare programs. The idea that rebates will stimulate growth was refuted more than 40 years ago by economist Milton Friedman, who won a Nobel Prize for his research. He proved that people's spending is mainly a function of what they view as their permanent income. When they have temporary income gains, they tend to save them; when they have temporary losses, they borrow or draw down saving to compensate. Therefore, consumer spending will not automatically rise just because people have a one-time gain of a few extra dollars in their pockets. More than likely, they will just save the money or use it to pay down debt, which is the same thing. Many studies of past rebates and other temporary tax changes have confirmed the truth of Friedman's theory. Now, studies of last year's tax rebate are confirming it anew. In 2001, all taxpayers and many who pay no taxes received checks of up to $300 per person ($600 for couples). These checks were mailed out during August and September. The theory was that people would immediately run out and spend them as if they were sailors on 24-hour shore leave. This would boost spending, which would raise growth. But as Friedman's theory predicted, no such thing happened. This is confirmed in a new study by University of Michigan economists Matthew Shapiro and Joel Slemrod. They surveyed a large sample of consumers before, during and after the rebates, and found that only about 20 percent was spent, and the rest saved or used to pay down debt. In the aggregate, there was virtually no change in consumer expenditures. The fact is that if you want people to raise their spending, you have to increase their "permanent" income. This means that permanent tax cuts will have more impact on spending today than a rebate of larger size. In other words, Congress basically did the opposite of what it should have done last year. It gave out large one-time rebates, while causing all other tax cuts to expire in the year 2010. For this reason, making last year's tax rate reductions permanent will do far more to increase spending than more give-away rebates. There is no reason to think that the latter -- or variations thereof, such as a payroll tax "holiday" -- will do any more to raise growth now than it did last year. It will simply be a waste of money. Any serious effort to revive growth would better focus on investment, not consumer spending. Consumption has actually held up quite well all throughout the economic slowdown. Since the beginning of last year, personal consumption expenditures have risen 4.5 percent and government consumption has gone up by 5.9 percent. It is only because gross private domestic investment has fallen by 4.8 percent that the gross domestic product is up by just 2.5 percent.