Stimulating debate on rebates' effects

The White House keeps insisting that the rebates and withholding tinkering in its tax programme will noticeably contribute to recovery by serving as an "economic stimulus".

Still, the changes in the works - $600 cheques in the mail, withholding adjustments to reflect single percentage point cuts in rates - seem rather small to be worthy of that grand title.

Economically oriented observers have two other reasons to gripe. The supply-siders among them do not believe that marginal changes to consumer shopping ability actually have the power to lift the economy. They would rather see a focus on incentives for the economy's producers. Others argue that consumers are more likely to hold on to the money than spend it, as the White House wishes.

This is too pessimistic, say a pair of economists who took the time to make a case study of another, earlier, White House withholding experiment. In fact, say Matthew Shapiro and Joel Slemrod of the University of Michigan, consumers actually do spend extra cash when they get it*. And when they spend they stimulate the economy to a significant degree.

The withholding change at issue was implemented by President George Bush, the father of the current president, during his grim election year of 1992. Frustrated at his inability to get Congress to put through a strong stimulus package, Mr Bush senior penned an executive order reducing standard withholding rates.

In what turned out to be his final State of the Union address, the president said his withholding shift would pump a full $25bn into the economy. It would represent "money people can use to help pay for clothing, college, or to get a new car".

These big promises, note the study's authors, were premised upon tiny-seeming amounts: married couples with two workers received $57.60 extra in take-home cash a month. Singles got only $14.40.

What is more, the 1992 break - unlike the current one - was not even a genuine tax cut. It was merely an advance on citizens' annual tax refunds from the Internal Revenue Service. The whole story seemed dismissable as so much election year desperation.

But when the economists attached questions about the change to Michigan's Survey of Consumers, they found that a full 43 per cent of taxpaying households said they would indeed spend most of the extra take-home pay. "The direct impact of the policy would be to increase consumption by an $11bn annual rate", conclude the authors, worth a not insignificant 0.2 per cent increase in gross domestic product.

In other words, the 2001 withholding changes and summer rebate should be the stimulus the White House promises, since they involve larger amounts. The president's number crunchers think GDP growth will be a full percentage point stronger in the second half of 2001 than it otherwise might have been due to the tax cuts.

This will not convince the old-fashioned classical economists and supply-side skeptics, who believe that talk of the power of consumer demand, multipliers, and so on is so much Keynesian claptrap. But there is also a classical argument for the Bush stimulus. It is Milton Friedman's theory of permanent income, which says that citizens adjust their spending and saving based on their best estimates of their own earnings prospects over the long run.

This theory would say that the already legislated tax cuts of 2001 have sent a signal to voters: in future they will get to keep more of their money.

Both before and during the 2001 rebate period, these citizens will begin to spend more, confident in the knowledge that they can afford such spending better than they could have before the tax cut became law.

By the same principle having Republicans in the White House ought to help as well. That is because Republicans tend on balance to be greater tax cutters, or are at least more reluctant to raise tax than are Democrats. So the chances that pocket books will be fatter in the new millennium are generally greater. This is the "first, do no harm" theory of politics.

Alas, the same logic also suggests that consumers may not spend quite so much as the Bush White House desires. That is so for two reasons. The first is that Democrats have now captured the Senate, reducing the scope for future hoped-for cuts.

The second has to do with the actual tax legislation itself. The president's opponents insisted he "sunset" the bill, so that every rate cut is set for repeal at the end of the decade. In other words, the "permanent" extra income at issue is clearly not as permanent as it could be. All material to ponder when the cheques arrive.

*Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding, The American Economic Review, March 1995.

© Copyright 2001 Financial Times

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