A couple of weeks ago, I wrote my newspaper column about Gov. Mike Easley’s commission to reform the state tax code. While some of the ideas were valuable and worth a closer look, I criticized the panel’s argument that all future tax cuts should consist of temporary tax rebates rather than permanent changes in tax rates.
I made the point that any incentive effects of tax cuts are pretty much eviscerated when producers and consumers perceive them as fleeting. When taxpayers see the tax code as being permanently changed, for better or worse, then they are more likely to factor the changes into their financial planning and act accordingly.
A few days after writing the piece, I stumbled across a February 2002 paper by the Joint Economic Committee of the U.S. Congress that served to reinforce my point. It was entitled “The Effects of the Duration of Federal Tax Reductions: Examining the Empirical Evidence.”
The congressional researchers concluded that most people “smooth” their consumption over their lifetime based on how much they expect to earn over a lifetime. That is to say, most people are rational planners — not perfect ones, of course, because perfect information about the future is impossible. They are not fools who can be easily tricked by government officials, as economist Milton Friedman observed decades ago.
“According to the available evidence,” the report stated, “individuals respond more strongly to a permanent federal tax rate reduction or other permanent tax incentives than to a temporary federal tax reduction or tax rebate.” By testing various economic models, the report found that phasing in tax cuts or offering rebates can reduce the growth-enhancing effects of the change by one-half to two-thirds, depending on the assumptions used.
None of this matters if you believe that tax cuts do little more than redistribute income. If the goal is to take money from Person A (through higher taxes or spending reductions) and give it to Person B, a one-time rebate can probably accomplish that (assuming that Person A doesn’t successfully evade). What such a policy can’t do is make both Person A and Person B better off. Marginal tax cuts, on the other hand, are designed to increase overall production of goods and services so that Person A gains by helping Person B gain, and vice versa.
Easley officials say that tax rebates might be an appropriate tool to use once North Carolina reaches its “optimum” mix of tax rates. Perhaps in theory, but the reality is that we are far away from such a mix. I am afraid that adopting a rebate policy would preclude any future rate reductions. That’s bad news.