NCPA - National Center for Policy Analysis

Permanent Tax Cuts

November 25, 2002

Economist Milton Friedman proved 40 years ago that people's spending is mainly a function of what they view as their permanent income.

  • When they have temporary income gains, they tend to save them; when they have temporary losses, they borrow or draw down saving to compensate.
  • Therefore, consumer spending will not automatically rise just because people have a one-time gain of a few extra dollars.
  • More likely, they will just save the money or pay down debt, which is the same thing.

Studies of last year's $300 per person tax rebate confirm his research.

  • The theory was that the tax rebate would boost spending and raise growth.
  • Actually, only about 20 percent was spent and the rest saved or used to pay debt, according to consumer surveys by University of Michigan economists Matthew Shapiro and Joel Slemrod.
  • Overall, there was virtually no change in consumer expenditures.

Permanent tax cuts will have more impact on spending today than a rebate of larger size. Thus, making last year's tax rate reductions permanent will increase spending more than give-away rebates.

And any serious effort to revive growth would better focus on investment, not consumer spending -- which has actually held up quite well all throughout the economic slowdown.

  • Since the beginning of last year, personal consumption expenditures have risen 4.5 percent and government consumption has gone up by 5.9 percent.
  • It is only because gross private domestic investment has fallen by 4.8 percent that the gross domestic product is up by just 2.5 percent.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, November 25, 2002.

 

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