January 18, 2008

Why Tax Rate Reductions Are More Stimulative Than Rebates: Lessons from 2001 and 2003

by Brian M. Riedl

WebMemo #1776

With slower economic growth raising fears of a recession, Washington is abuzz with economic stimulus proposals centered on tax rebates. Tax rebates, however, don’t stimulate the economy. Lawmakers currently examining economic stimulus proposals should reject rebates in favor of tax rate reductions. Tax Rebates Don’t Stimulate By definition, an economy grows when it produces more goods and services than it did the year before. In 2007, Americans produced $13 trillion worth of goods and services, up 3 percent over 2006. Economic growth requires four main factors: (1) an educated, trained, and motivated workforce; (2) sufficient levels of capital equipment and technology; (3) a solid infrastructure; and (4) a legal system and rule of law sufficient to enforce contracts and contain a functioning price system. High tax rates reduce economic growth, because they make it less profitable to work, save, and invest. This translates into less work, saving, investment, and capital–and ultimately fewer goods and services. Reducing marginal income tax rates has been shown to motivate people to work more. Lower corporate and investment taxes encourage the savings and investment vital to producing more and better plants, equipment, and technology. By contrast, tax rebates fail, because they do not encourage productivity or wealth creation. To receive a rebate, nobody has to work, save, invest, or create any new wealth. Supporters of rebates argue that they “inject” new money into the economy, increasing demand and therefore production. But every dollar that government rebates “inject” into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another. (Even money borrowed from foreigners brings a reduction in net exports.) Supporters of rebates respond that redistributing money from “savers” to “spenders” will lead to additional spending. That assumes that savers store their savings in mattresses, thereby removing it from the economy. In reality, nearly all Americans either invest their savings (which finances business investment) or deposit it in banks (which quickly lend it to others to spend). Therefore, the money is spent whether it is initially consumed or saved. Given that reality it is more responsible to let the savers keep that money for a new home or their children’s education, rather than to have Washington redistribute it to someone else to spend at Best Buy. Simply put, low tax rates encourage working, saving, and investing, which in turn encourages job creation and wage growth. Tax rebates merely redistribute existing wealth…….Click here to read more