by V. Kumar

Created on: June 08, 2008   Last Updated: July 28, 2008

Tax rebates are a very effective tool, a tool that CAN WORK, PROVIDED they are used to induce the changes that are desired, and not just to augment the spending power of the masses.

EFFECTS OF TAX REBATE

Tax rebate has two important effects - First, it increases spending power of taxpayer; second, it changes economic behavior of taxpayer.

While the first effect is always there. The second effect will depend upon the design of the tax rebate - a conditional tax rebate associated with a particular economic choice will modify behaviour of people towards that choice. It is the second effect that can make tax rebates work, not the first one.

PAST EXPERIENCE & KEYNESIAN THEORY

Some may like to counter me with a reference to history. After all, the whole Keynesian economics is based on the success of killing the great depression by augmenting spending power of the people. Unfortunately, what worked in great depression cannot work in each and every situation.

Even the tax cuts during the eighties and nineties can be quoted as examples of how tax rebates always lead to economic boom. It is true that tax cuts in many countries during the last couple of decades have given a positive dividend, but then, before attributing it to tax cuts, one need to analyse how those tax cuts were introduced. All those cuts were actually more in the form of rationalization of tax rates, or more specifically the maximum marginal rates, which did not affect the whole of the economy. Most of these cuts actually reduced the maximum marginal rates while raising the tax collections. In other words those tax rationalizations lead to higher tax collection, leaving lesser money for spending. Yet they were successful because they reduced the inefficiency of the economy and lessened incentive for evasion.

LAFFER CURVE

There is a concept in economics called 'Laffer curve'. The underlying principle of this concept is that when the tax rates are too high, then reducing the rates actually increases collections, but once the tax rates are reasonable, then any further reduction will reduce the tax collections.

Tax cuts work only till the point they do not lead to reduction in tax collections. That, unfortunately is not the case today.

If the revenue at the disposal of government falls, it can have severe impact, on social infrastructure, as well as in investments oriented towards future growth. After all, in United States, public saving has been an important component in capital formation and a fall in it will definitely stall future growth.

CONCLUSION

If tax rebates are used to accelerate spending in areas that have a crucial bearing on future economic scenario, they can prove extremely effective. The areas which deserve these tax breaks include energy efficiency, alternative fuels, solar energy, local manufacturing, innovation and social infrastructure especially higher education in basic sciences.

Learn more about this author, V. Kumar.
Click here to send this author comments or questions.