May 15, 2001 | Backgrounder on Taxes
Both houses of Congress recently completed their work on the budget resolution for fiscal year (FY) 2002.1 In addition to increasing federal spending, Congress has voted to return $100 billion in excess tax revenues, spread across this fiscal year and FY 2002, to those who pay income or payroll taxes. This is good news for nearly every American household; the tax relief should help the flagging economy if it focuses on increasing the incentives to work and save--in other words, if Congress delivers a tax relief package in a way that will reinforce the capital heart of the economy.
Although policymakers are eager to provide immediate tax relief to help stimulate the economy, a number of politicians want to deliver it through tax rebates instead of lower tax rates. Having the federal government send checks to people, however, will do far less to help the economy than can be done by reducing their tax rates. In addition to being bad economic policy, as history has shown, rebates also are bad tax policy. If lawmakers genuinely want to increase the economy's performance, they should use the money policymakers are considering for rebates to make further permanent reductions in tax rates on work, saving, and investment.
Because the budget resolution (H. Con. Res. 83) calls for $100 billion in immediate tax relief but does not direct how this relief should be delivered, Congress faces a choice: Either have the government send checks to selected beneficiaries (a rebate) or endorse sound tax policy and make a downpayment on long-term tax reform by cutting tax rates and making other needed, pro-growth tax policy changes.
If Congress chooses tax rate reductions and uses the $100 billion to accelerate tax relief and make the reductions retroactive to January 1, 2001, the effect on the economy will be significant. Calculations by analysts in The Heritage Foundation's Center for Data Analysis indicate that:
The combination of lower tax rates and the
repeal of death taxes, marriage penalty reform, and an expanded
child tax credit would
produce 1.6 million more jobs over the next 11 years, compared with economic forecasts under current tax law.
From a political perspective, tax rebates are attractive since constituents would get a check in the mail. But rebates have little economic impact. Choosing rebates over further tax rate reductions would squander an opportunity for Congress and the President to boost both short- and long-term economic performance with sound tax policy.
|How Tax Rate Reductions vs. Rebates Would
Affect the Economy
Some advocates of returning excess tax revenues to taxpayers through rebates believe that this method is just as effective in stimulating economic activity as is making reductions in marginal tax rates. However, a test of these two approaches using the WEFA U.S. Macroeconomic Model showed that a tax rate reduction would do much more for the economy than would rebates of equal size, even over a period of just two years.
Heritage analysts simulated a rebate program that paid out $52 billion in FY 2001 and $51 billion in FY 2002, and compared that simulation with one of a tax rate reduction of $52 billion and $51 billion, respectively, in those same years. The results of this comparison are most instructive.
A one-time payment from the government is not a tax cut and will do little to stimulate the economy. Instead, a tax rebate is a throwback to the failed fiscal policies of the 1970s. The evidence shows, for instance, that the Gerald Ford tax rebate did not help the economy, and the same type of policy will not help today. More specifically:
Rebates have little stimulative effect on the economy. Tax rebates, a throwback to widely discredited Keynesian economic theory, are based on the notion that the government can jump-start the economy simply by putting money in people's pockets. According to this theory, people will spend the money, and the increase in the demand for goods and services will ripple through the economy, leading to more jobs and increased economic output.
If Keynesian economics had any validity, the U.S. economy would have boomed in the 1970s after the 1975 rebate was enacted. Researchers failed to find any beneficial impact from that rebate, however, and President Jimmy Carter withdrew a similar proposal in 1977 when the Democrat-controlled Congress criticized it as being an ineffective economic stimulant.2 Moreover, the Japanese government enacted a whole series of Keynesian "stimulus" packages in the past decade that resulted in a 10-year economic stagnation, not economic growth.
Even if Keynesian theory were correct, it would be impractical because the money that the government would give consumers must come from somewhere. In the 1970s, the tax rebate was financed by deficits, which meant that there was less money available for investment spending. The result: no increase in aggregate spending. Today, in a budget surplus environment, a tax rebate does mean less debt reduction; but this simply means that the government is taking money that would have been put in the "pockets" of bondholders and putting it in the "pockets" of rebate recipients instead. Again, the result is no increase in aggregate demand or total spending.
Rebates are really a form of government spending. It should not be surprising that rebates have little stimulative effect, because a rebate is really the same as a government spending program. Tax relief occurs when government does not take money from people in the first place. A spending program occurs when the government collects money and then gives it to someone. Even if policymakers decide only to give rebate checks to taxpayers, this does not change the fact that the money is cycled through Washington and therefore represents government spending.
Indeed, the Senate Budget Committee acknowledged this fact when the original Senate budget resolution was adopted on April 6, 2001. In their technical analysis, the rebate was counted as spending in Budget Function 920 (Allowances) instead of being added to the tax cut totals.3
Supply-side tax policy is the way to boost economic growth. Supply-side economics recognizes that tax rate reductions help the economy by encouraging people to produce more. The economic stimulus occurs because the tax penalty on productive behavior is reduced, not because there is more money in people's pockets. In other words, when lawmakers reduce marginal tax rates on work, saving, investment, and entrepreneurship, people have an incentive to produce more, which means more economic output and therefore more income available for both consumption and savings.4
This explains why supply-side tax cuts, such as the Kennedy tax cuts in the 1960s and the Reagan tax cuts in the 1980s, are associated with economic expansions. The lower tax rates--as well as substantial reductions in the tax burden imposed on business--encouraged workers, savers, investors, and entrepreneurs to engage in additional productive behavior. More jobs were created and incomes rose.
Congress can implement the tax relief called for in the FY 2002 budget resolution by combining the tax rate reductions in the Economic Growth and Tax Relief Act of 2001 (H.R. 3) with substantial death tax relief and marriage penalty reductions. This sound approach to tax policy would permanently lower tax rates on work, saving, and investment. Moreover, if policymakers made all of the tax rate reductions in H.R. 3 retroactive to January 1, 2001, they would provide $103 billion in tax relief from FY 2001 to FY 2002 without having to resort to tax rebate gimmicks.5
To understand how the economy would respond to lower tax rates, Heritage economists used the WEFA U.S. Macroeconomic Model6 to conduct a dynamic simulation of the legislation. They reconstructed WEFA's December 2000 long-term model to embody the economic and budgetary assumptions published by the Congressional Budget Office (CBO) in January 2001. These are the same economic assumptions that Congress adopts when it frames and passes its annual budget resolution. This specifically adapted model then uses CBO budget assumptions to produce dynamic simulations of policy changes.
Increase economic growth. Lower income tax withholding in the second half of 2001 and additional tax rate reductions in 2002 would increase the rate of economic growth by 0.1 percentage point this calendar year and 0.4 percentage point in 2002. By the end of FY 2011, GDP (adjusted for inflation) would be $248 billion higher than the CBO baseline forecast without the tax policy change.
Create more job opportunities. Over 1.6 million more Americans would be working at the end of FY 2011, compared with the CBO baseline forecast. Moreover, the unemployment rate would average just 4.7 percent instead of 4.9 percent from FY 2001 to FY 2011.
Increase family income. By the end of FY 2011, real disposable personal income (income after taxes, adjusted for inflation) for a family of four would increase by $4,644.7 In response to this increase in family budgets, consumer spending would rise by $257 billion, or $3,422 for each family of four.
Increase family savings. By the end of FY 2011, a family of four would be able to save $1,087 more (adjusted for inflation) than the CBO baseline forecast.8 This higher level of personal savings is reflected in a higher savings rate, which on average is 0.7 percentage point above the baseline forecast of the CBO without the tax policy change.
Rebates will not stimulate the economy as much as will marginal tax rate reductions. Tax rebates may be attractive from a political perspective, but they have little economic impact. Congress and the President should boost short-term and long-term economic performance by adopting sound tax policy: specifically, by cutting marginal tax rates.
Supply-side tax policy is the way to boost economic growth. Tax rate reductions help the economy by encouraging people to produce more. When lawmakers reduce the penalty on work, saving, investment, and entrepreneurship, people have a greater incentive to produce more. Policymakers should ignore the siren song of rebates and pursue sound tax policy that lowers tax rates across the board and leads to economic growth, more job opportunities, and increased investment.
William W. Beach is Director of the Center for Data Analysis, and D. Mark Wilson is a former Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies, at The Heritage Foundation.
3. See Summary Proposed FY2002 Budget Resolution H. Con. Res. 83/Domenici Substitute, Committee on the Budget, U.S. Senate, p. 53, at /static/reportimages/C3E632ADAFDDAF3020199201E08A4DDE.PDF (May 3, 2002).
4. Larry Kudlow, "Rethink the Rebate: It's the Wrong Economic Medicine," National Review Online, March 26, 2001, at http://www.nationalreview.com/kudlow/kudlow032601.shtml.
6. The Heritage Foundation's Center for Data Analysis used the Mark 11 U.S. Macro Model of WEFA, Inc., formerly Wharton Econometric Forecasting Associates, to conduct this analysis. The model was developed in the late 1960s by Nobel Prize-winning economist Lawrence Klein and several of his colleagues at the Wharton Business School of the University of Pennsylvania. It is widely used by Fortune 500 companies, prominent federal agencies, and economic forecasting departments. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, and do not necessarily reflect the views of, the owners of the model.