The Federal Rebate Plan vs. Tax rate reduction

Steve Kirsch (stk@propel.com)

Why you should care

By May, Congress will have decided on some amount to return to the taxpayers. Say that figure is $1.2 trillion over the next 10 years.

The question facing them at that time will be: what's the best way to return that money to the taxpayers? Lower tax rates? Or a rebate? 

I've spoken with Tom Daschle and he'll be pushing in the Senate for rebates. In Oregon, they have a tax rebate called "the kicker." It has proven to achieve all the benefits the Republicans have articulated as the reasons for a tax cut. Sadly, the facts don't seem to matter to the tax cut proponents. 

As you'll see below, there is no valid argument that a cut is better than a rebate.

You should care because, after all, it's OUR money!

The Federal Tax Rebate Plan

Instead of a $1.6 trillion tax cut, leave taxes exactly where they are now. Every quarter, we calculate the amount of money that the government has spent (including  rebated and put into special reserve funds) over the previous 12 months. If the government has spent less over the past 12 months than they collected over the past 12 months, we return the excess dollars to taxpayers, in proportion to the amount paid in taxes. There is a minimum threshold payout each quarter. If the calculated rebate is less than the minimum, the minimum is paid out to taxpayers.

There are a number of variations on this plan (e.g., annual payout at Christmas instead of quarterly payout as is done in Oregon, etc.) that are summarized below, but the paragraph above is the basic concept.

The arguments

Lower tax rates have the benefit of certainty at the potential expense of running deficit budgets if tax revenue projections are not correct.

On the other hand, a properly structured federal tax rebate plan provides a greater number of benefits than rate cuts

  • It returns the exact same amount of money back as a tax cut (if and only if 10 year projections on tax revenue and spending requirements are as accurate as claimed)
  • It provides a guaranteed minimum level of certainty of some money back no matter what happens (the minimum threshold payout described below)
  • It has the potential for returning more to taxpayers than the currently promised static rate cut so it's totally aligned to Bush's "we should return YOUR money." There are several scenarios under which that can happen: (a) the economy does better than expected, (b) government spends less than projected, (c) Bush doesn't get re-elected and the Democrats raise rates.
  • It has the flexibility to respond to changing needs in an emergency
  • It aligns everyone's interests to keep spending under control since the size of the rebate check is proportional to the size of the government savings. Today there is no such alignment. The government can run up huge deficits and no taxpayer will notice anything different because nothing changes for the taxpayer.
  • It holds government accountable for controlling spending since taxpayers will see the benefit if they do better than expected (and see the benefit in their pocket). There will be increased public visibility and scrutiny on federal spending and waste because there will be a reason for the public to be interested in tracking this since it will affect the size of their rebate check.
  • It dramatically increases the chance of a balanced budget (due to a combination of increased accountability and the fact that the rebate is only paid out above the minimum threshold payout if there is a surplus)
  • It is a much more responsible and flexible way to allocate funds since, unlike a static rate cut, it allows adjustments if things don't go as planned on either/both revenue and expense sides (collecting more or less revenue than projected or spending more or less on major projects that we can't accurately cost out at this time, such as nuclear missile defense or newly proposed education initiatives) without running deficits. 
  • Once instituted, it will be much harder to take away than a tax cut. Tax rates seem to change all the time. Once instituted, it will keep the pressure on government to reduce spending forever.
  • It still allows government to create special "lockbox" accounts for improving education, providing a reserve for social security, paying down the debt, and so on, since the surplus to be refunded is calculated after all such expenses and reserves are paid out.

A rebate program is supported by Democrats and Republican voters that I've spoken with. A rebate  supports the key Republican goals of cutting government spending, increasing accountability, returning excess money not used to taxpayers, and balancing the budget.  The currently proposed rate cut provides none of these benefits. Isn't it time to try a new approach? Democrats favor the rebate as well because it is a more responsible way to administer public funds.

Alternative options

  • Rebate formula: Pay the rebate as some combination of (a) proportional to the amount paid in taxes (b) per capita (c) inversely proportional to the taxpayers AGI (but in no event more than amount paid in) (d) inversely proportional to the amount paid in taxes. For example, we could pay the rebate equally out to all taxpayers (up to a maximum of what they paid in taxes). This has the advantage of making the rebate larger for most people. This isn't subsidizing the poor since it is just reducing their tax bite to zero, not giving them more money than they earned. However, the rebate formula does open the door to subsidize low-income taxpayers, if that is the desired outcome.  So there is a lot of flexibility here, a lot more than a simple tax cut would provide.
  • Rebate timing: Pay the rebate annually instead of quarterly. Pay it out in November, in time for Christmas. Retailers will love this. This may make it simpler to administer and the check will be 4 times larger than quarterly checks so it will look more significant.
  • Congressional bonus: Give Congress a bonus proportional to the amount of the rebate. This aligns things even more so that everyone is rewarded if budgets are balanced and spending is kept under control. 
  • Forego option: Allow people to forego their rebate. This will increase the rebate that everyone else will get and thus it provides a mechanism for people to contribute to helping out taxpayers directly. Today, there is no way I could make such a contribution, even if I wanted to.

Q&A

Q: Interesting idea. But it's never been done before. We can't try something new. It's too risky.
A: Actually it isn't new. It's done in Oregon (it's called the "kicker") and it works great. They've had it for over 5 years now. Everyone (Republicans and Democrats) loves it. You get your rebate once a year around Christmas time. It's now an institution and is so popular, it's impossible to get rid of. It is more effective than anything else in keeping spending under control and cutting waste.

Q: Rebates don't provide the certainty that a tax cut would provide.
A: If everything goes as you planned (spending under control and revenue projections exceed spending), then you get the same $1.6 trillion dollar tax refund. So to the extent you weren't fibbing about your economic projections and promises of what government would do, the rebate is the same as the rate reduction. Also, certainty isn't the issue that we are trying to solve. The issue we are trying to solve is keeping government spending under control and returning the savings to the taxpayers. A rebate would accomplish both and a tax rate reduction accomplishes neither. If the economy doesn't go as you projected, and tax revenues are smaller, the rebate payout is less, but then, so would your savings be under a tax rate cut. And if the economy zooms, taxpayers will benefit due to the windfall of receiving a lot more more money back than a static rate cut would provide. Lastly, and most importantly, tax rate cuts are not guaranteed! If Bush doesn't get re-elected, the Democrats could raise rates again. A tax rebate is much more likely to survive since the Democrats like it too because it's fair.

Q: A tax cut will force government to spend less. Rebates won't because there will be more money available to spend.
A: Years of experience have made it clear that short of a balanced budget amendment, nothing will force the government to spend less. Here's a quote from Trent Lott arguing for the Balanced Budget Amendment:

SEN. TRENT LOTT, Majority Leader: (January) For 28 years weve not had a balanced budget. And itll be at least probably four or five more years before we would have one. Weve had good men and women make commitments to balanced budgets, including presidents. Weve had laws on the books. But as a matter of fact, we think that it takes more than a plan to have a balanced budget, or an agreement to get a balanced budget. We think the constitutional requirement is absolutely essential. And its what I call satisfaction guaranteed.

So clearly a tax cut won't force government to spend less. So why not try a new approach? Today, deficit spending isn't visible. If the government  runs a huge deficit or a small deficit today, the average taxpayer won't know because they don't see it. Rebates will make deficit spending much more visible to taxpayers because every taxpayer will see it as a reduction in their quarterly rebate checks.

Q: Rebates are a great idea. So are tax cuts. Why not do both? A big tax cut and rebates for anything left over after that!
A: The reason rebates work is that the rebate check is big enough to pay attention to. If you make a maximal rate cut and start the rebate at zero (under current optimistic projections), it's a non-event. But if you put that guaranteed tax cut in the form of a rebate that varies based on performance, then people start to see it. Also, from a Bush administration point of view, people will associate the Bush administration with creating all this "new wealth" and be reminded of it every single quarter instead of a one-time event that they will quickly forget about.

Q: A tax cut will incentivize people to work harder because it affects marginal rates. A rebate, since it represents a pure income effect, has negative incentive effects -- it would lead to increased consumption of leisure and less work. We judge tax cuts by incentive effects, measured by the marginal rate. Rebates apply to something in the past, not to incentives for the future.
A: The assumption that changing marginal rates provides incentives is debatable, as pointed out in this article. The effect, if real, is marginal at best. For example, if your boss told you that he's doubling your pay tomorrow, will you work harder now? Or will you work half as hard since you'll still maintain your standard of living? I'd guess some will work harder since they are being paid more, and some will slack off since they no longer must work as hard. So rather than focus on a marginal benefit, it's smarter to focus on the other objectives: permanence, cost control, and returning excess funds to taxpayers. These are truly better served by a rebate than a tax cut and all three effects are proven in Oregon. Furthermore, there's no reason that the rebate can't be proportionally higher for rich people. Since the he rebate is based on the amount of taxes paid in...the more you earn, the higher your rebate. So there is a direct correlation between working hard and higher rebate checks. That seems consistent with your incentive intent. 

Supporters
Laura and Gary Lauder
Joe Costello, CEO, Think3
John Dillon, CEO, salesforce.com
David Liddle, Partner, US Venture Partners
Rod Diridon, Executive Director Mineta Transportation Institute

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