Category: Economics

A cliché can be dangerous sometimes. It can be so because behind a cliché is an implicit assumption of generalization which ignores differences that exist between cases. A cliché is especially damaging when it begins to be repeated by a whole lot of people who lack comprehension of the original context which introduced the cliché came into being in the first place. It amplifies an already faulty generalization. This is evident in debates surrounding the second stimulus package expected to be announced this coming March: government spending advocates’ criticism against effectiveness of tax cuts are based too much on clichéd generalization.

A particular criticism that needs response is the assertion that tax cuts do not encourage spending. While there are multiple parallel instances supported by mainstream economic theories to back that up in specific scenarios, recent incarnation of the argument has its origin in the first stimulus package planned by the Bush administration which was subsequently approved by the Congress in February 2008. The central theme of the package was one-time tax rebates.

For the purpose of clarity, tax rebates could be seen as back-dated tax cuts. The US government implemented the program by returning to taxpayers’ part of the taxes they paid in 2007.

Many economists were skeptical of the effectiveness of the one-time tax rebates because of the works of at least four prominent individuals working separately — John Maynard Keynes, Irving Fisher, Franco Modigliani and Milton Friedman. Modigliani and Friedman were Nobel laureates. There is no doubt that if the Nobel Prize in Economics were introduced earlier when Keynes and Fisher were alive, they too would have won the Prize.

While Keynes and Fisher set the foundation of the debate, Modigliani and Friedman placed the keystone. Modigliani and Friedman’s works indicate that consumption, savings and everything in between depend on long term patterns. Friedman through his permanent-income hypothesis especially proposed that those items are really dependent on future income, or in his own phrase, permanent-income.

The implication of the hypothesis is clear: temporary changes to income do little to affect current consumer behavior.

Months after the passing of the stimulus package as proposed by the Bush administration, US taxpayers finally received their tax rebates. Soon, data were in and consensus forged. The result was mostly in the negative and yet another blow to the already battered Bush administration.

The stimulus — though it did raise consumption by a tiny bit — largely failed to stimulate the US economy. What mostly happened was that the recipients of the rebates either saved the extra money or used it to finance their debts. It did not create enough additional demand to keep the economy going. It did not stop an economic avalanche of historic proportions from happening.

The same conclusion was arrived previously, as examples, in 1964, 1968, 1975 and 2001 in the US when temporary changes to the US tax rates were introduced only to fail to affect the economy. In Malaysia itself, the same conclusion could probably be reached with respect to the one-time fuel rebates dispensed in June 2008 though the objective of the rebates is hardly to stimulate the economy. Alas, I am unaware of any local study into that matter.

Yet, somehow, policymakers never learned from these episodes of natural experiments. Worse, not only did far too many individuals fail to learn from the past, many others outrageously reached at the wrong conclusion.

Many are already passing judgment that tax cuts as a whole do not work, citing the failed 2008 Bush’s tax cuts as proof. This has become the cliché argument against suggestion for tax cuts to be included in the second stimulus for Malaysian economy in March 2009.

During the course of the debate, the so-called experts in various banks and think tanks in the media have begun parroting the line, without making reference to the 2008 episode. The loss of reference — removal of the key phrase ‘one-time tax rebates’ — slowly generalizes the debate in the mind of the public, especially in the mind of those without basic economic training. With that crucial qualification gone, it further encourages the generalization that tax cuts do not work.

Far from correct however, the cliché disastrously missed the point. The lesson from 2008 is the lesson of Friedman’s permanent-income hypothesis. Temporary tax cuts do not affect current consumption. Instead, permanent or sufficiently persistent changes to the tax rates do.

The differences between temporary and permanent changes are not the only victim of the clichéd generalization made against tax cuts as part of a larger debate on government spending and tax cuts as part of effort to stimulate the local economy. Another generalization is that all tax cuts are the same, be it on personal income tax, corporate income tax, sales tax and tariff, among others.

Apart from the effectiveness of tax cuts, the size of tax cuts is also questioned given that taxpayer base in Malaysia is small. A person said to me, “even if tax cuts are effective, it will not make a dent here.”

Yet another supposedly heavy punch directed as proponents of tax cuts is that tax cuts mean nothing to loss making companies. Companies do not pay tax if they make losses.

The two arguments, while directed to tax cuts as a whole, are only relevant to personal income and to some extent corporate taxes only. Somehow, the size of sales and service taxes and its contribution to transactional cost are conveniently forgotten.

What has been ignored is that tax cuts on transactional taxes reduce procurement cost for companies and increases revenue for others, depending on elasticity of supply and demand. By cutting these taxes, the government could help companies to stop bleeding, retain their employees and directly on the macro level slow down the rising unemployment rate.

The bottom line is that differences do matter. Therefore, it is imperative to notice the differences between temporary and permanent changes as well as the existence of different kinds of taxes while not falling into the trap of generalization. Tiresome clichés propagated by parrots meanwhile need to be disposed of in favor of more precise arguments conscious of the context we are in.

First published in The Malaysian Insider on February 23 2009.