January 27, 2003 | WebMemo on Taxes
Fiction: Temporary tax cuts will induce additional consumer spending leading to a healthier US economy. This added consumer spending is needed to "stimulate" the economy.
Fact: Temporary tax cuts are a recycled version of tax rebates, both of which people see as transitory, and will do very little to help the economy. Consumption, as a percentage of Gross Domestic Product (GDP), has been at an all time high for the past two years. Consequently, more consumer spending cannot be expected to "stimulate" the economy.
Individuals work, save and spend based on how much income they expect to earn on an ongoing basis. This is the main argument behind Nobel Laureate Milton Friedman's permanent income hypothesis. The idea is that people do not change their patterns of working, saving and spending based on transitory changes to their income. The temporary tax cut proposed by Senator Tom Daschle (D-SD), therefore, will not achieve its stated goals.
For example, after seeing their tax bills reduced for the current year, taxpayers would know that their future tax bills will rise to previous levels. In other words, people understand that the temporary reduction amounts to a future tax increase. In essence, Daschle's so-called "temporary tax cut" amounts to a tax rebate, an equally ineffective type of tax policy.
The idea of using a rebate to stimulate the economy was also tried in the 1970's when every American received a rebate. That plan was also unsuccessful in stimulating the economy. Since the temporary tax cut and the rebate are essentially the same plan, there is no reason to believe that either will be successful this time. Both ideas have been discredited and should be removed from serious policy debates along with the very notion of "stimulating the economy" by inducing more consumer spending.
The prudent tax policy would be to lower marginal tax rates permanently so that people are allowed to keep more of the next dollar they earn. This type of tax reform will remove distortions from individual's incentives to work, save and spend. Permanently lowering marginal rates, along with flattening the tax brackets and eliminating burdensome taxes on capital, would do the most toward improving people's standard of living by supporting a significant, long-term expansion of economic activity.
For more on Friedman's permanent income hypothesis, see Milton Friedman, "The Permanent Income Hypothesis: Comment," American Economic Review, Vol. 48 (December 1957), pp. 990-991.