NCPA - National Center for Policy Analysis

A Tax Rebate Won't Raise Consumption

March 28, 2001

Democrats say a tax rebate will provide the economy with a quick stimulus. We did exactly what they are recommending 26 years ago, and it had no impact on the economy.

  • The Tax Reduction Act of 1975 was enacted in the midst of the deepest recession in postwar history, and checks were mailed out quickly.
  • Taxpayers received a 10 percent "refund" on their 1974 taxes, with a minimum of $100 and a maximum of $200.
  • This added about $8 billion to disposable income -- close, in today's dollars, to the $60 billion rebate now being proposed.

But most people didn't spend the money, and thus there really was very little economic stimulus: they saved it or used it to pay down debt.

This is explainable by the "permanent income hypothesis" developed by Nobel Prize-winner Milton Friedman. He found people tend to spend according to what they believe their permanent income is. Hence, when they got a temporary income increase, they saved it. Conversely, if they suffered a temporary income reduction, such as through a job loss, they borrowed to maintain their consumption. Only a permanent change in income, such as a permanent tax cut would significantly increase consumption.

Subsequently, a study by Franco Modigliani (another Nobel Prize winner) and Charles Steindel for the Brookings Institution found no more than one-fourth of the rebate was spent in the following three quarters.

And a 1981 study by Alan Blinder, later a Clinton appointee to the Council of Economic Advisers and the Federal Reserve Board, concluded rebates deliver just 38 percent of the impact of a permanent tax cut.

By 1978, Jimmy Carter and Congress reduced capital gains tax because they recognized that encouraging investment was a better way to increase growth than subsidizing consumption.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, March 28, 2001.


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