Sunday, June 8, 2008

$600 Rebate Check: 2008 Economic Stimulus

$600 Rebate Check: Time for some retail therapy!

- (amateur) Economics and History behind the tax rebates


Hopefully by now everybody has received their rebate check. Bush’s popularity as a President may be down (I don’t understand why it was up to begin with!), but certainly he gets Brownie points for this generosity. Now who does not love a freebie? There are few who did not make it because they made more than 75K! They have a reason to complain. But we don’t see them complaining because those who write financial columns most likely don’t make 75K when they file IRS taxes: Not because they evade taxes (ofcourse they make a hell lot of money!), but because they do “tax planning”! Inspite of the so called tax planning, if they have to pay taxes, they hate taxes in general and think Government robs them of their money and by returning $300/600/1200, there is no favor being done anyway. Infact “tax rate” relief and not “tax rebate” is the key to a stronger economy: a view that certainly helps those who pay lot of taxes, but targeted for the same reason at many other places such as: http://www.taxpolicycenter.org/briefing-book/background/stimulus/options-avoid.cfm.

So when I searched the web for articles that can impartially look at the prospects of this tax rebate and its proposed merits, I found none that could challenge the belief on why it should work in the first place? There was a lot of debate in happy 2001 days, but by 2008, the situation is desperate and every mouth is open for any morsel that falls. So all articles I saw just assumed there is a merit, but how much requires number cranking and you can find most of the statistics at Moody’s Economy.com (http://www.economy.com/dismal/article_free.asp?cid=102598). On the other hand, there are articles on what an average Joe on the street thinks about the merits of this tax cuts. Ofcourse they are not happy because ultimately we have two kinds of Joes: ones who do not want Government to tax at all because it does not know how to use the money wisely; and the others who having lost their money in real estate frenzy or other stupid investments, and instead of taking responsibility for their own actions, now want the same Government to do more! Convenient, huh?!

Let us get back to the original more serious question: the proposed merit of a tax rebate; which is to stimulate a sluggish economy. Let us trace back its history and the origin of the popular myth before we discuss the relevance of such a cut in current economic conditions. We do not need to go too far back in human history. Modern economics rose from the ashes of Great Depression. After the turmoil of Great Depression and World War II, most western economies, and US in particular, were having great run offs in most of the 50’s. However the cold war policies led US Government to have its tentacles spread at more places than what it could handle and with Cuban Missile Crisis, the Government was in deficit and economy was growing sluggishly. It was 1962 and JFK was the President. Further at that time, after having analyzed Great Depression, various economic theories had propped up and were competing against each other. However, with Walter Heller as the chairman of Council of Economic Advisors, Keynesian approach to stimulate the economy got a chance for trial, an approach in which it was thought that Government policies could be used to create demand. Heller decided to do so by proposing tax cut. It was a revolutionary idea because the Government was in deficit. A nation’s economy was still governed by the model of household finance: you have to balance your budget and make ends meet. Nevertheless, Kennedy endorsed it and proposed $10 billion tax cut and L. Johnson signed the tax cut into law called “Revenue Act of 1964”. Miraculously by 1965, the economy was back on track and what was revolutionary became conventional wisdom!

Tax cuts/rebates known as stimulus bills have since been enacted in 1971 (Nixon), 1975 (Ford), 1981 (Reagan) and 2001 (Bush) (which was rather a surplus bill). Well not all of them have been successful in what they promised to achieve. Nixon’s Revenue Act of 1971 was a complete failure possibly because it was accompanied with other ridiculous policy decisions such as price and wage control. Ford’s 1975 tax cut returned the magic of 1964 while Regan’s 1981 tax cut does not seem to have achieved anything if it did not create a disaster. It was ultimately followed by tax rate increase to cut the deficit.

So what does history teach us? A wise man would say that the evidence is inconclusive, while the statistician would add that even the data is insufficient. It is a gamble. Yet politicians love it and how can one blame them. When has life been that easy... you are loved for a popular move that can actually help! Keynesian theory has since been rejected by many, but this aspect of the Keynesian theory is hard to give up! Excuses have been given when the tax cuts did not work. One excuse that was popular in 2008 decision was that many tax cuts were not swiftly enacted. Only a timely action helps. Strangely, in an effort to cover up the lost cause of Regan’s tax cuts, no one from Bush administration said that it did not achieve its promise possibly because it was not accompanied by spending cut as Regan had promised. Bush, on the other hand, can not even promise a spending cut.

Still it is an interesting question to consider why the tax cut worked the first and the third time? There are supply side arguments that seem most plausible. Generally when the economy is having a good run off, as it was happening to US economy in most of the second half of twentieth century, production increases to satisfy the ever-surging demand. However, information dissemination can be slow or inaccurate, and the mismatch between demand and supply can lead to inventories build up faster than the increase in demand. This leads to decrease in manufacturing output, create temporary unemployment as the plants close down, thereby creating minor recessions in the economy. The problem is very similar to age old problem of farmers. When the price of a certain commodity rise, next season every farmer shifts to the cultivation of that produce, thereby bringing the price of that produce low, but soars the price of stuff that is now scarce, bringing starvation to farmers in return! It is the world of traders! Tax rebate in such a situation just gets people to spending spree and they help remove the build up inventories out of the shelves.

So far so good! This is a rosy picture. One can wish that every situation is similar to the one described above. If the problem is created due to inaccurate information dissemination, how can one be sure that the problem is due to hiccups created by inventories build up? Economists are smart people and no matter what their arguments are, they are nervous of their own proposals and that is the reason for many consumer indices. The argument is that if the consumer is healthy, economy is inherently healthy. How do you know that consumers are healthy (well same as wealthy!!)? This is an age old cause and effect problem. If you measure it by their discomforts such as unemployment ratio, then it may be the effect of the problem and not the cause of the problem. Tax rebate is a bait to go out and spend if it is just a temporary discomfort and show that they are actually well off and will party given an excuse!

Unfortunately, it seems when economics meet politics, even the best of the economists, no matter how well trained in Econometrics 101, seem to fall into the pitfall of cause and effect, when they are promoting policy decisions. Typically Catch-22 is a beautiful situation for endless arguments as you can turn around facts to promote what you believe in. And when you give this tool to politicians, what you have is a disaster. Kennedy himself was not immune to it, rather a big victim of it. In the analysis by Prof Miller published at http://tapes.millercenter.virginia.edu/news/shreve_taxcut_2001.pdf, it is shown that the Revenue Act of 1964 was aimed at demand and not the supply. Kennedy actually believed that deficit is good and the demand expansion is good. This has inadvertently meant consumption is good as summarized in following words of Kennedy: “When consumers purchase more goods, plants use more of their capacity, men are hired instead of laid off, investment increases and profits are high”. The legacy and temporary success of Heller’s tax proposal is that it goes far beyond the merit of tax cuts. It has led to the most popular economic myths and brought this planet to the verge of ruin. Blindly it is assumed that American economy recovers because of endless and meaningless consumption. In a typical cause and effect blunders, demand aspect is taken to be the cause of economy’s health rather than realizing that an increased demand reflects economic health. As much as ancients have celebrated austerity and self-restraint, in modern America, consumption is celebrated, and the rest of the world wants to emulate it. Heller, in his later years, himself was concerned by the recurrent misuse of his economic policy.

Coming back to tax rebate, we see that the purpose of tax cuts hardly targeted the supply side inventory build up (though it coincided in rare cases). Further using tax cut as a bait to see if the consumers are healthy in an economy is down right stupid because it is based on the assumption that people are wise and know how they want to spend the excess money they get. The utility maximization theories are good on paper. On the other hand, in Bush’s 2008 stimulus proposal, consumer’s health is hardly a question because we all know it is bad if not really bad. But, as misguided as it has always been, tax cuts have always been justified based on the fact that it increases demand, creates consumption and consumption is good. Now statistics on Economy.com can show how much the GDP increase would be and how much employment it would create. There are bars, charts and figures. It all looks intimidating to an untrained eye such as mine. But it is the same trap as pointed by Henry Hazlitt in “Economics in One Lesson” some 50 years ago. Those who have read the book can see the “broken window fallacy”. GDP increase most likely will be contributed by inflation and deficit. As far as increase in employment is concerned, it could have happened if the same money would have been invested wisely by someone who would be accountable for it.

Now if I have made anyone who read this article angry at me for saying they did not deserve the $600 they received, then please forgive me. I am a bum, and I love free money. If nothing else, there is some welfare aspect to this rebate. It just balances the wealth among the people. Those who had nothing will get $600. Those who had something will see that the inflation reduce the value of their saving by a bigger fraction than the $600 they received :)

2 comments:

Living Off Dividends & Passive Income said...

only people with atleast $3000 in earned income were eligible for this - so real bums got shafted along with the "super" rich (thats anyone with $75k of AGI).

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