With slower economic growth raising fears of a recession, Washington is abuzz with talk of economic stimulus plans.
President Bush may offer a stimulus package; congressional leaders are discussing a proposal centered on tax rebates. Tax rebates don’t stimulate the economy. Cutting tax rates does.
To explain, let’s take a step back. 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) A motivated, educated and trained work force.
(2) Enough capital equipment and technology.
(3) A solid infrastructure.
(4) And a legal system and rule of law sufficient to enforce contracts.
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 that results in fewer goods and services. Reducing marginal income tax rates has been shown to motivate workers to work more. Lower corporate and investment taxes encourage the savings and investment vital to producing more plants and equipment, as well as better technology.
By contrast, tax rebates fail because they don’t encourage productivity or wealth creation. No one has to work, save, invest or create any new wealth to receive a rebate.
Critics contend that rebates “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 (and even money borrowed from foreigners reduces net exports). No new spending power is created. It is merely redistributed from one group of people to another.
The same critics respond that redistributing money from “savers” to “spenders” will lead to additional spending. That assumes savers store their savings in their mattresses, thereby removing it from the economy. In reality, nearly all Americans either invest their savings (where it 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.
Therefore, isn’t it more responsible for the saver to keep that money and save for a new home or their children’s education, rather than have Washington redistribute it to someone else to spend at Best Buy?
Simply put, low tax rates encourage new wealth creation. Tax rebates merely redistribute existing wealth.
Take the 2001 tax rebates. Washington borrowed billions from the capital markets, and then mailed it to families in the form of $600 checks. Predictably, consumer spending temporarily rose, and capital/investment spending temporarily fell by a corresponding amount. This simple transfer of existing wealth did not encourage productive behavior. The economy remained stagnant through 2001 and much of 2002.
It was not until the 2003 tax cuts — which instead cut tax rates for workers and investors — that the economy finally and immediately recovered. In the previous 18 months, businesses investment had plummeted, the stock market had dropped 18 percent, and the economy had lost 616,000 jobs. In the 18 months after the 2003 tax rate reductions, business investment surged, the stock market leaped 32 percent, and the economy created 5.3 million new jobs. Overall economic growth doubled.
Thus, both economic theory and practice show the superiority of tax rate reductions over tax rebates.
On the spending side, the same economics apply. Programs aimed at injecting money into the economy will fail because that money first must be removed from the economy. And proposals to have Washington subsidize state governments would not change the amount of total government taxing and borrowing. Such policies are based on redistribution, not productivity.
True, education, training and highway spending could theoretically increase productivity and therefore promote long-term economic growth. However, that assumes Washington won’t divert highway money into worthless pork projects and bridges to nowhere, and that more education and training money are directly correlated with better performance. (Previous large budget increases had almost no effect.) There is little reason to trust Washington politicians to make the right public investments.
Instead, the 2003 tax cuts showed that proper tax policy can encourage the working, saving and investment that fuel productivity and economic growth. Combined with proposals to reduce bureaucratic red tape and support free trade, tax rate reductions are the best way for Washington to remove barriers to economic growth.
Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Roe Institute for Economic Policy Studies at the Heritage Foundation.