Advisors to presidential hopeful Barak Obama have proposed a tax 'rebate' scheme, perhaps funded by confiscating oil profits, to spark economic recovery. While there may be political payoffs from such populist posturing, the proposal lacks any economic merit.
On the one hand, most of the funds from such a one-off payment would go to those that pay little or no federal income taxes. On the other hand, recipients that pay taxes would simply have the 'rebate' deducted from their current obligations. In both instances, the rebate would constitute a transfer payment that can have not real stimulus effect.
A cure for what ails the U.S. economy can be found in the playbook of Indonesia's president and legislature. Instead of offering populist placebos like rebates, they cut the top income tax rate to 30 percent from 35 percent and reduced brackets while granting higher deductions to make Indonesia a more attractive place to do business. Corporate income will be taxed at a flat rate of 28 percent next year and 25 percent the following year and dividend taxes will fall to 10 percent from 20 percent, as of Jan. 1, 2009.
It turns out that neither tax refunds nor rebates can stimulate the economy by increasing the demand for consumer goods. Tax rebates are usually funded with either budget deficits or an inflated money supply or both whereby excessive demand fuels price inflation and bubbles.
To determine the best response to an economic slowdown, it is important to know what causes them. Unfortunately, economists disagree on the nature and cause of business cycles. Even so, one theory consistently provides explanations of past recessions as well as the one that seems to be rearing its ugly head.
In simple terms, business cycles are predictable and certain outcomes of central bank policies that lead to excessive provision of credit from artificial lowering of interest rates. As such, booms and busts do not arise from innate elements of a market economy.
Artificially-cheap credit sets off what is often referred to as a boom. Therein, actors in sectors highly-sensitive to interest rates invest in capacity cannot be sustained by real economic conditions. Of particular importance is that the existing real amount of savings cannot accommodate new spending on capital goods arising from an inflated money supply.
Booms based upon cheap-credit expansions orchestrated by central banks are like pyramid schemes. Firms may be aware of a likely bust, but they have an incentive to invest early in the boom to earn substantial profits that might offset later losses.
A second stage, known as a bust or a recession, occurs when central banks begin to halt credit expansions by tightening monetary and credit conditions to relieve inflationary pressures. As they push up interest rates, retrenchments occur in the same interest-sensitive sectors that were induced to invest "too much" during the boom.
As the U.S. economy struggles to work through a cycle created by irresponsible central bankers, the Congress tried to reverse the process with a "stimulus" package. Other tried-and-failed policy nostrums are offered, including lower interest rates combined with tax rebates and some additional government spending.
The underlying logic behind all these notions is if insufficient spending causes recessions, then they can be averted by boosting expenditures. A simple reality check readily shows the errors in this argument.
If insufficient consumption were the source of economic problems, everyone should go on a spending binge. But this contradicts every sensible notion about how household budgets look to the future and avoid debt as much as feasible and to restrain consumption.
From the micro perspective, prudent family financing seeks future prosperity by deferring consumption and saving as much as possible. From the macro perspective, these funds are available for other to use for investments.
Economic logic should not be suspended when shifting analysis from a family budget to a national one. In the face of an economic slowdown, individuals and businesses are well advised and indeed are likely to save more. The rational response of individuals and businesses to spend less as a recession looms cannot be blamed for economic troubles of an unavoidable downturn.
While less consumer spending does not cause recessions, neither does is it a dangerous long-term trend. As households and business save more so others can invest, they provide the foundation for economic recovery.
Given the faulty economic logic that drives the arguments for stimulus packages, it is not surprising that experience proves they cannot bring their promised results.
Consider the impact of tax rebates. Political expediencies aside, tax rebates do not work in the real economic world. Tax rebates offer no encouragement for anyone to increase productivity and add nothing to wealth creation, both being prerequisites for growth. As is it, rebates are like manna from heaven without any extra exertion towards working or saving or investing or creating new wealth.
As it is, governments cannot give anything or spend unless funds are extracted from the pockets of taxpayers or by issuing debt that takes away from future taxpayers. And since rebates are derived from taxes or new borrowing that removes money from somewhere in the economy, they cannot create any new net spending power. What happens is merely redistribution from one activity or group of people to others.
Since higher government spending and tax "rebates" do nothing for long-term growth, there can be no positive revenue feedback effect and the result will only be higher public-sector deficit. If the Obama camp wishes to create a positive lasting effect on the U.S. economy, they should ring up Jakarta to find out how permanent tax cuts promote increased savings and more prudent investment.
The writer is Research Scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala. He can be reached at CLingle@ufm.edu
