We've seen in 2001 and 2008 that tax rebates fail to bring economic growth. And it's not even a matter of whether they are saved or spent. Its about productivity and labor supply. Reducing marginal tax rates increases incentives to work, save, and invest -- which results in greater labor supply, more productivity, and as a result, more growth. But tax rebates do none of that -- no one has to work, save, or invest more to get a rebate. In that sense, rebates just redistribute the pie rather than expand it. Washington borrows $100 billion from investors, and gives that $100 billion to consumers. So investment spending drops (since the financial system would have otherwise applied those investment funds elsewhere), and consumer spending rises. And in the long-run, the shift from investment to consumption spending should even reduce productivity. Yet voters like rebates, so the game continues.

Tax policy is an area of economics where evidence and theory agree: long-lived, anticipated cuts in tax rates predictably affect behavior, but short-lived cuts in taxes, especially if they are not related to tax rates (e.g., lump-sum rebates), will not have much effect. The remarkable thing about the recent tax cuts -- Bush's in 2008 and Obama's in 2009 -- is how poorly designed they were (in contrast to Bush's earlier tax cuts). This is a further indication of how divorced policymaking in Washington has become from rational economic analysis. But I am an optimist. I believe, to paraphrase Winston Churchill, America will always do the right thing, after it has tried everything else. The pendulum will soon swing back to rational economic policy, the sooner the better.

Whether tax rebates or spending, there are two issues: (1) does it make good policy sense in the first place, and (2) in time of recession, is it likely to provide stimulus? Jeff Frankel speaks somewhat favorably of the "Making Work Pay" tax credit relative to higher-income efforts, but that credit basically is a flat grant to most workers. I think it's time to start thinking about low-wage subsidies--in particular, for those single persons and low-earning married persions largely left out of the current EITC. It's cheaper, provides more bang per buck recession-wise, and is more pro-work than unemployment compensation. It can be designed as good long-term policy to provide work incentives (at least relative to other expenditures or tax breaks), reduce marriage penalties, and, as a matter of welfare policy, give an some alternative to some low-income people, particularly young males with relatively high incarceration rates.

See http://www.urban.org/UploadedPDF/901333_gwd04012010.pdf

The economy is still weak, calling for additional stimulus in the short-term. At the same time, however, adjusting the reckless long-term fiscal path that we have been on at least since 2001 grows more urgent every year. The obvious goal for any stimulus should be to maximize bang for the buck. “Bang” means short-term stimulus to demand. “Buck” refers to the long-term cost in terms of the national debt. Intelligent fiscal policy could get us where we want to go. Yet one of the two political parties amazingly continues to insist on measures that minimize bang for the buck, rather than maximizing the benefit/cost ratio, just as it did in 2001 and 2003.

To answer the National Journal’s question, temporary tax rebates such as the one passed in 2008 do very little to stimulate demand because, yes, they are mostly saved. That is the implication of standard economic theory and the conclusion from empirical studies. Other measures with extraordinarily low bang for the buck would include re-instating two Bush tax cuts that are due to expire in January: the income tax cut for families earning above $250,000 and the abolition of the estate tax. Tax measures with higher bang for the buck include extending Obama’s Making Work Pay program; lower income workers have a higher propensity to spend than the rich (and also in many cases face higher effective marginal income tax rates if one really cares about the importance of incentives). But the highest bang-for-the-buck at this point would come from public spending, in particular, more aid to hard-pressed states so they don’t have to lay off bus drivers, teachers, policemen, and construction workers.

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