Tax Cuts, Triggers and Rebates, Oh My!

Commentary by Pete du Pont

In recent weeks, two ideas have gained popularity among those who don't want to see the president's tax cut plan enacted. One idea is for an immediate one-time rebate of a portion of this year's surplus, the other is to add a trigger to any tax rate cut. A quick look at history, however, shows that both ideas would be harmful.

First, let's look at the rebate idea. After spending the fall decrying the idea that the economy was faltering and blasting Bush's tax cut plan as too large, many Democrats now want to cut every worker in America a check for $300, arguing that money needs to be put into consumers' pockets as soon as possible to reverse the now undeniable economic slowdown.

The problem is that we did exactly what the Democrats are proposing 26 years ago and it didn't work. As my colleague Bruce Bartlett recently recounted, in the midst of the deepest recession in postwar history, Congress gave taxpayers a 10 percent "refund" on their 1974 taxes. This added about $8 billion to disposable income - close to the $60 billion being proposed in today's dollars. Yet most people didn't immediately go out and spend the money as predicted, and thus, there was very little economic stimulus. In fact, most people either saved their rebate, or used it to pay down personal debt.

The rebate's failure as a stimulus can be explained by Milton Friedman's "permanent income hypothesis." Friedman's theory states that consumption doesn't automatically go up and down with disposable income. People tend to spend according to what they believe their permanent income is - something only a permanent rate reduction can affect.

In that respect, any kind of trigger mechanism on a permanent rate cut would transform it into a temporary one. A tax trigger is a law providing that enacted tax cuts will only become operative if budget surplus numbers reach or exceed a predetermined target. What's wrong with that? History shows that they don't work, and can actually bring significant economic consequences.

The 1985 Gramm-Rudman-Hollings law, which was supposed to reduce deficits by limiting congressional spending, contained a spending trigger. The idea was that if a given year's deficit-reduction targets were not met, spending would be automatically cut. Great idea, but it didn't work because Congress simply evaded the law by employing a variety of accounting gimmicks.

A trigger on tax cuts would work the same way. If the trigger depends on projected surpluses, the Congressional Budget Office could massage the data to maker sure the next year's tax cut is cancelled. If the trigger depends on actual budget results, Congress could simply shift the timing of expenditures by one day, from one fiscal year to another.

All of which raises serious questions. Once the trigger is pulled, what actually happens? Congress is unlikely to repeal a tax cut in the current year - can you imagine asking people to give back money when the government has a large surplus, but just not quite large enough? But how late in the year can the trigger cancel next year's tax cut?" What if the tax cut is cancelled in December, but the economy surges in April? Do we get next year's tax cut back retroactively?

Suppose we are heading into a recession in November, so a tax cut is needed to spur growth, but the surplus targets are not met, and the tax cut scheduled for January is cancelled. Do we really want locked-in counter cyclical influences in fiscal policy? Or consider the reverse: inflation is ticking up, so the Fed wants to raise interest rates. Higher interest rates will raise government spending and decrease the surplus, and perhaps pull the trigger on the next tax cut. Should the Fed bend monetary policy to take into account the trigger's impact?

Most importantly however is the effect it could have on the spending decisions made by average Americans. Suppose a wife plans to use the tax cut to help pay the tuition at college to get the degree she needs to get a better job. It's September; tuition is due. But congressional spending is close to pulling the trigger. Will she get her tax cut or won't she? The trigger can adversely effect decisions on many big-ticket items - depressing consumption rather than stimulating it.

Bush would be wise to reject any rebate that is not directly tied to long-term tax rate cuts. He should also avoid any triggers, which would only tell taxpayers, "we're passing this tax cut now, but don't count on it."