Rethinking the tax rebate

Recent signs of a slowing economy and dramatic jolts to stock-market prices have galvanized many Republicans and Democrats in Congress to favor an immediate $60 billion tax cut, including a one-time tax rebate of $300 per person. After the loud fighting over President Bush's tax plan, a bipartisan consensus may appear comforting. But don't be fooled. Consensus doesn't make the rebate a good idea.

If an impending recession is the problem, why not just pass the president's tax plan? The answer is that, despite the administration's protests to the contrary, its tax package is incredibly poorly designed to fight a current recession. The original plan offered no tax cuts in 2001. It is hard to see how a plan can provide stimulus if no taxes are changed. In 2002, cuts of only $21 billion ($75 per person) were proposed. The tax bill that passed the House earlier this year did slightly better, offering $6 billion in cuts in 2001. But in a $10 trillion economy, these cuts are trivial. Indeed, by endorsing an immediate $60 billion cut, the president implicitly admits that his plan would do next to nothing for the economy, short term.

The desire to cut taxes is understandable: Both parties want to be seen as doing something for the economy now. But that's where agreement ends; in fact, both sides are using the rebate to strengthen their positions on the administration's tax-cut plan.

Democrats want to be able to vote for a tax cut, but think the administration's plan costs too much and gives too much to wealthy households. They want to pass the stimulus package now and postpone debate on the long-term package.Republicans want to use a bipartisan stimulus package as a vehicle to help push through an increasingly problematic administration tax proposal. They argue that the effects of tax relief will be enhanced if short- and long-term policies are combined into one package.

But before politicians rush in to pass a consensus package, it is worth considering a few issues.It is not clear that a stimulus is needed. Although the economy is slowing, the duration and severity of the downturn are debatable. Most intermediate and long-term forecasts for the economy remain relatively rosy.

If a stimulus is needed, a one-time rebate is unlikely to succeed. In the past, by the time Congress has passed a stimulative package, the economy is often already rebounding. In addition, actually getting the money to people, either through IRS checks or changes in employer withholding, is much more complicated than it might seem, and would cause further delays. Even if the policy were implemented quickly, the stimulus would come from added consumer spending, but experience with the 1975 rebate suggests that much of the funds would be saved.

There is virtual professional consensus among economists that tax policy is not the way to fine-tune the economy. As a result, debates about whether to structure the stimulus as an income-tax cut, a rebate, or a payroll-tax holiday are really third-order considerations. If we actually knew how to control the economy at such a minute level, we would not be in the current economic situation.

So, who's right? Well, both sides are, to some extent. The Democrats are correct that a desire to cut taxes now should not require passage of the president's tax plan. The Republicans are right that combining short- and long-term tax relief makes more sense than doing each individually. But both sides are wrong in emphasizing the idea that a stimulus package featuring a one-time rebate is likely to have any real effect on the economy over the next few months.

The best way to proceed is not to panic, but to focus on tax reforms that will lead to a better overall tax system. The right approach is a tax cut that is significantly smaller than the administration's proposal over the long term, is more tilted toward lower- and middle-income households, and is implemented sooner. A plan with these characteristics would do about as much as can be expected to stimulate the economy over the short term, but would be fiscally responsible and fairer in the longer term.

William G. Gale is a senior fellow in economic studies at the Brookings Institution.

(c) Copyright 2001. The Christian Science Monitor