Tax rebates legitimately are powerful tools to help the economy instead of manipulative ploys to distract citizens from real national problems. Whether and how tax rebates benefit the economy, however, largely depends on the state of the economy itself when the rebates are given. Normally, tax rebate policies can distort the economy by crowding out investments and causing trade deficits, possibly leading to an economic recession. On the other hand, when the economy already suffers from a credit crisis (as it does currently in May 2008), a tax rebate can be the much-needed rainfall after a drought that pulls the economy out of recession.
During either the normal or boom period of a business cycle, tax rebates may not be as beneficial to the U.S. economy, and may even cause greater harm than good. One reason is that households are all rational and forward-looking. They realize that a tax rebate pushes the government budget in debt, which means that the government would need to raise taxes in the future to repay the debt. Essentially, the household’s lifetime disposable income does not change, and so people would keep their spending pattern the same and just save their rebates. People put the rebates in saving instead of spending them in order to pay for the anticipated future tax increase. In this situation, the fiscal policy would fail to stimulate the economy. In a graver case, tax rebates can cause the economy to contract. In distributing tax rebates, the government’s saving decreases, causing it to incur an enormous budget deficit. If households are not rational and forward-looking, they will spend the rebates instead of saving them. Thus, although consumption may rise, the U.S. total saving falls. Since the U.S. is large enough to affect the world loan scarcity, the supply of loans falls in the world market as well. The scarcity drives up interest rates, and thus the cost of borrowing skyrockets. To afford the high interest rate, firms must cut down on investments to attain higher productivity due to diminishing marginal returns. In this way, government’s tax rebate that resulted in budget deficit can crowd out investment. The government budget deficit can also cause a twin-deficit and damage the trade balance. Since savings in U.S. decreased, lenders must resort to borrowing from foreigners. Foreigners need dollars to buy U.S. assets, so the demand for dollars rises as borrowing from foreigners increase. The dollar appreciates, causing U.S. exports to seem more expensive to foreigners and foreign imports to seem cheaper to Americans. Thus exports decrease and imports increase, and the trade balance goes into deficit. Therefore, tax rebates’ net impact on stimulating the economy would be minimal, perhaps even backwards.
Although tax rebates can cause serious economic problems, it can actually be very beneficial during a credit crisis, as seen in the current economy. In 2007 and 2008, the fall in U.S. housing prices have frightened many lending institutions that made too many sub-prime mortgage loans. If their borrowers defaulted on the mortgage, the lenders receive the houses. Since the value of the collaterals has deteriorated, the banks and lenders themselves cannot repay their loans. Therefore banks and other investment firms do not have loans to offer households and private firms that may want to borrow, and the economy enters a “credit-crunch” crisis. The lack of loans drives down consumer and investment spending as households cannot obtain loans to sustain consumption, and firms cannot afford the high interest rate. Fall in consumption and investment means fall in U.S. aggregate demand, and thus a recession may result. Normally, rational households would save their rebates instead of spending them, and so the fiscal policy would fail to stimulate the economy. During this credit crisis, a tax rebate is the desperately needed solution. Credit-constrained households that have been delaying purchases of durable goods can now buy consumer goods with the tax rebates, and thus U.S. consumption rises. Firms can invest in new capital with the tax rebate, and so production rises as GDP rises. The rise in Consumption and Investment spending would bolster the U.S. aggregate demand, helping the economy to recover from a recession.
There is no absolute answer about whether a tax cut is beneficial, harmful, or even deceptive. Policy makers must consider the current economic situation in order to determine whether tax rebates are appropriate. Considering the current credit crunch crisis in May 2008, tax rebates would be most needed to help pull the economy out of recession.
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