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The ailing economy

With the US Economy still teetering at the verge of recession, the George Bush administration again resorted to tax rebates, as a means of salvaging the economy. In what the President referred to as “a booster shot for the economy”, a whooping US $168 Billion tax rebate package for tax payers, low income people, seniors living on government pensions and veterans who depend largely on disability checks. Under the package, businesses will also get tax breaks for investing in new plants and equipment.

Checks for the rebates are anticipated to start going out in May with individuals receiving a check of up to $600 and $1,200 for couples, with an additional $300 per child. Individuals earning above $75,000 and couples with income exceeding $150,000 would be getting smaller rebates marked by a reduction of $50 less for every $1000 income above these ceilings1. Explaining the rationale behind such moves, Johnson and colleagues2 assert that often times, policy makers attempt to employ tax policy as a tool for managing the magnitude of economic fluctuations.

Governments cut taxes when their economy faces recession, with the assumption that individuals and households will increase their spendings as a result of the increased take-home pay, thus reducing

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the severity of the economic recession. However, with the prevailing economic situation in the United States, this paper intend to argue that if the rebate stimulates any extra spending on the part of consumers at all, such spending will be restricted to only the amount of rebate received.

Interestingly, this position has already been strengthened by the recent poll carried out by Associated Ipsos which showed that only 19 percent of the people surveyed indicated that they plan to spend their rebate checks, with 45 percent expecting to pay debts with it and the remaining 32 percent hoping to invest the money3. The rest of this paper will examine studies carried out on consumer spending in the aftermath of the 2001 rebates and the literature on consumer spending habits to help illuminate the most probable consumption reactions to the tax rebate when it is eventually distributed.

Providing a background for the tax rebates policies of the Bush Government, Prof. Vernarelli explains that during the twilight years of the Clinton administration, the US economy was booming; experiencing budget surplus of two years in a row and increase in productivity. The economic climate forecasted by the Office of Management and Budget estimated a US $5. 6 Trillion in cumulative surpluses through 2010.

Creating his spending plan for such expected surpluses, George Bush, on campaign trail, allocated half of the sum for Social Security funds, a quarter for ‘important projects’ and the last fourth toward tax cuts for the people, thus the government created a tight situation for itself, so much so that even though the economy officially entered into recession less than three months into his administration, the promise of tax cut made to the people must be fulfilled4.

Unfortunately, while the 2001 tax rebates was geared towards economic upliftment, as much as towards following through on campaign pledges, subsequent tax rebates have been borne out of necessity. And with the dire state of the economy today, the anticipated tax rebates is one of the very few tools left for the government to deploy. There is no denying the fact that the economy was not this bad in 2001, therefore, it is only reasonable that if the rebates of 2001 stimulated increase consumer spending, such might be expected again, but to a lesser degree.

However, if the 2001 rebates did not stimulate any significant increase in consumer spending volume, it strengthens the statement of this paper that the 2008 rebates will perform even worst. In this regard, a brief overview of studies that evaluated consumer spending in the aftermath of the 2001 rebate distribution will be presented below; this will be followed by a discussion of the factors that influence consumer spending and then a conclusion. Agarwal, Liu and Souleles carried out one of the most recent studies on the reaction of consumer spending in response to the 2001 tax rebates.

Unlike most other studies that employ survey (questionnaire) techniques to measure consumer spending habits, this study made use of ‘a unique new panel dataset of credit card accounts’ in measuring consumer spending habits5. The primary aim of the study correlates with the argument of this paper, they intended to determine the extent to which consumers used the 2001 rebates to increase spending or to pay down debts using distributed lag models to estimate the month by month response of credit card payments, spending and debts to the rebates.

This study showed that after the rebates, consumers were more likely to save than spend the received money, as evident from credit card payments, although, afterwards, spending rose, offsetting the initial payments and returning debt to its original level. They also indicated that for individuals whose most intensively used credit card was in the sample, spending increased by an estimated $200 over nine month period after the rebates, this value represented a 40% of the average household rebate check.

While the authors concluded that this amounts to a large increase in consumer spending, it is pertinent to point out that the initial response of consumers was to save and the 40 percent in spending reported over a nine month period could have been influenced by a number of factors, outside the rebates, especially since the rebate did not stimulate increase spending immediately the checks were sent out6. Johnson and colleagues presented another study into consumer spending reaction to the 2001 tax rebate7. Their study made use of randomized sampling, to explore the random pattern in which the rebates checks were sent out.

The research instrument used was the Consumer Expenditure survey, with particular questions added to reflect consumer reactions to the rebate. The authors reported that for this study, change in household expenditures caused by the ‘pre-announced change in disposable income’ as a result of the tax rebate was estimated by comparing the expenditures of households who received different rebates at different times, to ensure that the causal impact of the rebate receipt on consumption expenditures was effectively measured.

The study showed that consumers spend about 20-40 percent of the rebate amount on non –durable goods. The most pertinent part of the result was that the only significant increase in consumption expenditure was recorded amongst the low income group, people generally classified as ‘facing liquidity constraints’ that is, people with low cash to go round. The authors admitted that no significant increase in consumption8 expenditure was recorded among respondents with high liquid wealth and no significant increases were also recorded in the next two quarters after the rebate receipt.

The study carried out by Shapiro and Joel for the National Bureau Of Economic Research (NBER) could be regarded as the most extensive study in this regard. This is because it is the only study that actually measured what consumers intend to do with the money they receive, instead of using some mathematical or economic model to estimate consumer reaction. Moreover, the study used an extensive survey instrument that was applied to a sample of the US population through three consecutive months. This extensive study revealed that only 21. 8 (approximated to 22) percent of consumers said they had or would mostly spent the rebate.

Of the remainder who would not spend the rebate, 59 percent said they would pay debts with the rebate money, while the other 41 percent would use the rebate to increase their savings. To add strength to this result, the authors also reported the result of the Gallup Poll released in July, 2001, where only 17 percent of the people surveyed said they would spend the tax rebate, 32 percent said they would save it and the remaining 47 percent would pay debts with it. From the studies reported so far, it is obvious that tax rebates do not always achieve the spending spree the government tend to expect when they cut taxes.

Even the most positive study of the 2001 rebate has reported less than 40 percent of increased consumer spending and this value was achieved only within the ‘liquidity constraint’ group. Shapiro and Joel10 explain that considering the fact that the tax policy in place in 2001 provided for ten years of tax cuts, the tax rebates apparently amounts to a substantial increment in lifetime resources, as a result, standard economic theory would expect the spending rate to get close to one, however, this is not the case in any of the studies reviewed above. Conclusion

It is safe to conclude that the performance of the 2001 tax rebates paint’s a vivid picture of what to expect from the recent tax rebates. In 2001, the economy was in a much stronger shape and with better prospects. The fear of economic recession was not as strong as it is now. Shapiro and Joel explains that factors that influence consumer spending reactions to tax policy includes concerns about whether government will reduce spending in future to compensate for the tax rebates; beliefs about the size of future tax rebates, the degree of indebtedness in the population and the degree of wealth holding.

This fact is better illustrated by the study of Auerbach, which analyzed national savings in the aftermath of the rebate. The author compared the revenue loss incurred by the government through the tax rebates, with the increase in income and thus potential increase in savings by consumers. It was reported that national savings increased in the short run, indicating increased savings by consumers11. Another factor that influenced the dismal performance of the 2001 rebate policy, as reported by Shapiro and Joel was that consumers were pessimistic about the size of future rebates.

Even among respondents with high and increasing income no more than a third expected to receive future tax cuts from the 2001 legislation. This factor should more strongly come into force now. With the bad state of the economy, very few people will expect this ‘manna from the government’ to continue. Moreover, the housing sector is in bad shape, stock market is not doing too well, and several other sectors of the economy are ailing already.

Thus, wealth holding capacity is falling as the debt profile of individuals and groups increase, not to mention several large banks declaring losses for the year ended. As would be expected, there is a pervading sense of fear and uncertainty in the population. All these point to the fact that people would be more likely to save for the uncertain periods ahead or pay off debts and bills, rather than go on spending sprees. Endnotes 1. International Herald Tribune, 2008; CHINAdaily, 2008 2. David S. Johnson, Jonathan A. Parker and Nicholas S. Souleles, 2004

3. Associated Press-Ipsos poll reported in the International Herald Tribune of February 13, 2008 4. see Vernarelli, Michael 2007 for a complete overview of the macroeconomic policy and environment during the first tenure in office. 5. Agarwal, Liu and Souleles, 2004 6. This argument is in line with Johnson et al (2004) contention that consumption should not respond to temporary changes in income, that instead, consumers should increase spending as soon as they learn about an upcoming tax cut and not when or after the take home pay has actually increased.

7. David S. Johnson, Jonathan A. Parker and Nicholas S. Souleles, 2004 8. It should be stated that the authors also reported that the rebate increased aggregate demand by y 0. 8 percent in the third quarter of 2001 and 0. 6 percent in the fourth quarter of 2001, although most of the expenditures went to nondurable goods and by the liquidity constraint group. 9. Matthew D. Shapiro Joel Slemrod 10. Shapiro and Joel 11. See Alan J. Auerbach, 2002

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