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Jewish World Review April 2, 2000/ 9 Nissan, 5761

Samuel Silver

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Consumer Reports

Senators, Tax Rebates, and the Nobel Prize -- Senate Democrats are promoting a plan that would give all American taxpayers a one-time rebate -- $300 for singles, $600 for couples-totaling $60 billion. They claim that this rebate is needed as immediate stimulus for the economy. They also claim that President Bush's long-term plan for reduction of marginal tax rates would not provide enough stimulus and will create a serious problem if future surpluses do not materialize.

They are wrong on all counts. Have these Senators not studied economics in the past 25 years?

Other than providing a system of laws and property rights in a stable monetary environment, the government cannot create economic growth, but it can definitely interfere with it through excess taxes, regulations, and bad monetary policy. The only positive action government can take is to reduce the barriers to growth (and freedom) that it has previously imposed. A reduction in income taxes impacts economic growth in two ways:

1. Lower marginal tax rates will create economic growth by encouraging increased work effort and by providing higher after-tax returns so investors and entrepreneurs will take more risks and create growth with additional investments. In all likelihood, lower marginal rates will increase tax revenues as the Kennedy and Reagan tax cuts did.

2. As tax rates are lowered, the original owners of the money may increase spending, which would increase aggregate demand in the economy. This is the hope of the proponents of a quick stimulus tax rebate for the economy. Unfortunately, there is a serious flaw with this concept.

There are three things consumers could do with a tax rebate: spend it on U.S. made products or services, purchase imports, or save/invest it, the latter being especially attractive in uncertain times. The only option that gives a quick kick to the U.S. economy is if they spend it on goods or services Made In The USA, and modern economics tells us that this won't happen with a temporary tax rebate.

The Keynesian theory behind government spending to stimulate the economy is based on the so-called "multiplier effect." The theory is that economic output increases by some multiple of the original change in spending. Therefore, if the Senate Democrats are following Keynesian economics (much of it long ago discredited), they believe that a one-time $60 billion tax rebate will increase economic output by some number greater than $60 billion. This assumes that most of the rebate is spent on U.S. goods or services.

Traditional Keynesian theory would say that the "marginal propensity to consume" is about .6, which means that 60% of a tax cut is spent on a combination of U.S. and imported goods and services. "New Classical Economics" concludes that a one-time tax rebate would have a minimal effect on consumption/spending, with the vast majority of the tax reduction going into savings! In other words, there will be little new spending for the multiplier effect to multiply, and there will be little short-term stimulus to the economy.

The underlying theory for such a small consumption impact is the "permanent income theory" of consumption developed by economist Milton Friedman in his 1957 book, A Theory of the Consumption Function. He developed it because empirical testing of the Keynesian model generated unexplained discrepancies, which he successfully explained.

Friedman demonstrated that consumer consumption was not a function of current income, but rather a function of permanent income or what a consumer perceived their long-term income stream (or wealth) to be. Consumers base their spending on what they expect their permanent income to be, not on transitory income such as a tax credit or rebate. That is why government schemes to "prime the pump" with tax rebates or credits have not been successful. For a tax cut to be a short-term "stimulus," consumers and business people must consider it "permanent" when performing their individual economic analyses. Friedman's theory has withstood the test of time and has been incorporated into both of the more recent economic "schools" of Rational Expectations and New Classical Economics.

Unfortunately, one of Keynes' major flaws was that he based most of his theories on the short run, as he believed that "In the long run, we are all dead." Since Keynes thought an individual's concern for the future is a "disgusting morbidity," he would have considered "permanent income" a truly aberrant thought. (For an analysis of Keynes erroneous ideas on the long run, see my article in JWR, "In the Long run, we are all dead – NOT!)

Is Friedman's "permanent income theory" some esoteric concept that Senators should not be expected to know about? Well, he was awarded the Nobel Prize in Economics in 1976 "for his achievements in the fields of consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy." The Royal Academy stated: "From a purely scientific viewpoint, one of Friedman's most important contributions is his reshaping of consumption theory with the help of the hypothesis about 'the permanent income'. . ."

Is it possible that the Senators behind this proposal are uninformed about modern economics? They probably are, but surely they have economic advisors, so perhaps they have another motive. Are they attempting to undermine a true long-term tax cut, albeit a relatively small one, which might be the start of a reduction in the power and control of the Federal Government over our lives?

The Democrats' argument about the uncertainty of future surpluses is also very questionable. If the government does not generate a surplus, it will more likely be due to a slowdown in the economy than a reduction in marginal tax rates. As previously mentioned, the Kennedy and Reagan tax cuts generated increases in government revenues, not decreases. And if the economy slows, even Democrats seem to think that lower taxes can help. Obviously, they are confused.

The best fiscal policy path the Democrats can take to create the environment for a strong economy is to provide "permanent" tax relief, returning "permanent income" to the taxpayers who are the rightful owners. And unlike their predecessors in control of Congress who created deficits during the Reagan years by excessive spending, they should help the President limit spending by at least the 4% annual growth rate he has proposed. Yes, they will lose some of their power, but that power will go back to the people where it belongs.

Samuel Silver, co-chairman of Toward Tradition, writes from Greenville, Mississippi. Comment by clicking here.


12/21/00: In the long run, we are all dead --- NOT!
12/12/00: Jesse Jackson predicts a "Civil Rights Explosion"
11/20/00: Al Gore’s Formula: Ignorance -- Fear -- Hatred
10/31/00: The 'Gender Gap' explained: Robbing Peter & Paul to pay Mary!
09/05/00: Republican Inclusion: Truth or Illusion?

© 2001, Samuel Silver