The View From 1776
Tuesday, January 22, 2008
Why Tax Rebates Are Delusional
One-shot tax rebates are just politicians’ feel-good narcotics for the voting public.
Two recent op-ed articles in the Wall Street Journal explain why one-shot tax rebates do nothing but raise future taxes and inflation, without helping to end a recession.
The primary reason is that recessions don’t occur because consumers decide to cut their spending. Consumers continue spending until well after the events that trigger recessions. One-time tax rebates do nothing to lower business costs of production or to whittle down excess inventories. They merely provide consumers with temporary funds employed in most cases to reduce personal debt.
Reality is that recessions occur when over-expansion of the money supply and concurrent lowering of credit standards cause excessive expansion of specific sectors of the economy. Output is increased beyond real underlying demand and producers’ costs become too high to permit lowering prices to levels at which consumers might continue to buy their products.
In the final years of the Clinton administration, excessive money expansion and low interest rates engineered by the Federal Reserve created the huge dot.com bubble that finally exploded. Today’s economic woes were created in the same way, with the housing boom playing the upfront role.
The quickest and least harmful way to end recessions is for the government to step aside and allow marketplace forces of supply and demand to compel businesses to reduce production while cutting costs and prices of over-supply goods. When businesses once again can produce products at prices and costs that generate profits, recessions end.
Bruce Bartlett in Feel-Good Economics writes:
But in 1974, the White House was keen on the idea of cutting taxes to stimulate private spending. Since it was feared that a permanent tax cut might be inflationary, President Gerald Ford and the Democratic Congress agreed on a one-shot tax rebate. One dissenter was economist Milton Friedman. His research had led him to conclude that consumer spending was less a function of liquidity than something he called “permanent income.” Thus Friedman predicted that the $100 to $200 checks disbursed by the Treasury Department in the spring of 1975 would have a minimal impact on spending, because they did not alter peoples’ permanent income.
Subsequent studies by MIT economists Franco Modigliani and Charles Steindel, and Alan Blinder of Princeton, showed that Friedman’s prediction was correct. The 1975 rebate had very little impact on spending and much less than a permanent tax cut—which would change peoples’ concept of their permanent income—of similar magnitude.
Read the whole essay.
Alan Reynolds in Bush’s Stimulus Flop amplifies the message:
Why all the political emphasis on promoting a one-year sales push for consumer staples [via a one-time tax rebate]? Recessions never began with a drop in consumer spending, except when credit controls were imposed (1980) and when price controls collapsed (1953, 1973).
The economy was in recession from March 2001 to November 2001, but consumer spending fell in only the first and last of those months, plus September. Real consumption last November was still 3% higher than a year before—not much below the post-1960 average increase of 3.6%.
We are nonetheless constantly told that consumer spending is the driving force behind economic growth or recession, simply because 70% of GDP is used to finance consumption. This demand-side fallacy arises from focusing on uses of income rather than sources. In reality, consumption depends on income and wealth, and income and wealth depends on business. If business is profitable, personal income from work and investments will rise and that will finance consumption.
Profits are partly dependent on sales volume, but also on margins. If a business is losing money on each widget, it won’t help to sell more widgets.
Read the full article.