Britain’s chancellor of the exchequer, Alistair Darling, did something rather strange recently to baffling applause from his own supporters and cries of “bribery” from the opposition: He announced a tax on teenagers.
Darling’s plan is to cut income taxes temporarily for all but the most prosperous taxpayers. The apparent windfall is £120 each—almost $230. If that sounds familiar, it isn’t surprising: A similar plan is already in motion in the United States, where a temporary “tax rebate” began to arrive in the bank accounts of a grateful nation about a month ago. The motivations are different in the British case. While the U.S. plan is billed as an economic stimulus, the British plan is marketed as compensation for those who lost out when taxes on some low earners were recently raised. No matter, because the practical impact of both plans is just the same: Teenagers are getting it in the shorts.
Here’s why: Since neither the U.K. nor U.S. government intends to alter its spending plans, these tax holidays will be funded by government borrowing, borrowing that must eventually be repaid. That will require taxes to go up in the future or not to fall when they otherwise might.
Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. Say her rebate check is $600; if she had wanted an extra $600 right now, she could already have it in her pocket, either by borrowing the money or by withdrawing it from savings. If she did that, of course, she would later have to pay $600 back plus interest. But that is exactly what some future administration will be demanding to repay government debt. Or, to look at it another way, the rational taxpayer should save the $600 windfall now, keeping it to pay the higher taxes that are surely on the horizon.
Whichever way you look at it, both the U.S. and U.K. governments are handing their citizens cash that was borrowed—and the citizens themselves are liable for the debt. If my bank manager arranged a surprise loan in my name and handed me the cash, I might feel pampered or put-upon, depending on whether I was planning to take out the loan myself anyway. Either way, doubt I would feel any richer.
Of course, some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: If the Grim Reaper knocks on the door before the IRS does, he can spend the tax rebate now and leave the bill for some other sucker.
Who will be the fall guy? We don’t know for sure because we can’t say whom a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom pay income tax today but most of whom will pay income tax in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.
The idea that a debt-funded tax cut makes little difference to anybody is called “Ricardian equivalance” after David Ricardo, one of the founders of modern economics. The equivalence is between government taxes and government borrowing. However government spending is funded, it generates a bill that will come due sooner or later. Far-sighted taxpayers will immediately take note.
Clearly, there are reasons why some taxpayers might care whether taxes arrive today, or tomorrow with interest. Even so, these tax gimmicks matter much less than we might think. It is current government spending, not current government taxation, that is the real measure of a government’s size.
Empirical economists are still arguing over whether Ricardian equivalence roughly holds, but one study by Matthew Shapiro and Joel Slemrod concluded that most U.S. citizens used a the 2001 tax windfall to pay off their debts, leaving more money available to pay future taxes—Ricardian equivalence in action.
That suggests that as consumers and taxpayers, we aren’t fooled by these games of three-card Monte. Are we fooled as voters? Alistair Darling obviously hopes so.