Of Public Interest

Volume 3, Number 6
May, 2001

Tax Rebates or Rate Reduction? Politics vs. Economics
by Richard E. Wagner

While a consensus seems to exist that some federal tax cut is a good thing, that consensus dissolves quickly when specific cuts are considered. President Bush proposes to cut federal taxes by $1.6 trillion over the next ten years. About one-third of this reduction would be accomplished through a reduction in marginal tax rates. In place of the three upper brackets that now range from 28 to 39.6 percent, there would be two brackets of 28 and 33 percent. To be sure, only $300 billion of that cut is projected to occur within the next five years. At an average of $60 billion per year, the amount of President Bush’s proposed reduction is about the same as the proposal advanced by Senator Joseph Lieberman to provide a $300 rebate to nearly everyone.

Despite their similar totals, there are strong differences in the economic and political implications of these alternative approaches to tax reduction. What is most significant economically about any tax is its marginal rate. This is the tax that is applied to the last dollar of income. Decisions to work, to save, and to invest are governed by the returns that people can expect to receive from their activities. The lower the marginal rate of tax, the higher the return that people can expect to receive from their economic activities. People will thus undertake more of those activities, and will undertake them more intensively. It is through these incentives, moreover, that taxes influence, for good or for bad, the extent of economic prosperity within a nation.

High marginal rates of tax are particularly harmful to economic incentives. If the marginal rate of tax is 50 percent, each $100 of added earnings brings only $50 to the person who does the earning. Should that marginal rate be reduced to 40 percent, each added $100 would bring $60. This is a quite large, 20 percent increase in the return to such income-earning activity. As marginal tax rates fall, the potential return from tax reduction falls as well. A reduction in the marginal tax rate from 20 percent to 10 percent would increase the return from $100 of added earnings from $80 to $90. This 12.5 percent increase in economic return is still significant, but it is weaker than a similar reduction applied to a higher marginal rate of tax.

What does all this have to do with the tax cut proposals offered by President Bush and Senator Lieberman? A great deal. A tax rebate does nothing to affect economic incentives, and so does nothing to promote the national prosperity. Tax rebates are mostly saved, in one form or another. There is nothing about a tax rebate that encourages people to expand their economic activities. Someone who faces a 28 percent marginal tax rate before the rebate still faces a 28 percent rate after the rebate.

In contrast, President Bush’s reduction in marginal tax rates would increase the return that people get from their economic activities. A reduction in the 28 percent rate to 25 percent increases the return on

$100 worth of activity from $72 to $75. This is a 4 percent increase in the rate of return. The economic incentive is even stronger for the reduction in the top rate from 39.6 percent to 33 percent. In this case, the return on earning and additional $100 rises from $60.40 to $67. This is an 11 percent increase in the strength of economic incentive.

Here we have two different ways of reducing taxes by roughly the same total amount. Tax rebates do nothing for economic incentive. Reductions in tax rates strengthen economic incentives, and strengthen them significantly. The general prosperity is clearly promoted by permanent reductions in tax rates. It is not promoted by temporary tax rebates.

Why, then, is so little play given to rate reduction? Even the Bush plan applies less than one-third of its tax cut to rate reduction. The answer perhaps lies in the natural reluctance of politicians to turn loose of tax revenues. A reduction in tax rates will take a good deal of political energy to reverse. Tax rebates and other forms of tax reduction are far easier to reverse. A rebate this year can relatively easily be stopped next year. It can also easily be pared back through restrictions on eligibility.

The natural instincts of most of the political animals who parade around Washington seem to be to treat reductions in tax rates as something to be avoided. A rebate or related form of reduction is less threatening than a reduction in tax rates. Someone who is concerned with the economic prosperity of the nation, however, would reverse this ordering of priority: reductions in marginal tax rates are clearly superior to rebates and related forms of tax reduction.

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