Tax Plan's Political Solution Offers Little for Economy

Taxpayers will begin receiving rebate checks this summer for breaks, such as the increased child tax credit, that are retroactive to Jan. 1, 2003. Now, if families take those checks and go shopping, there could be some uptick in consumer spending numbers -- although whether that's enough to turn this economy around seems unlikely. But if history is any guide, families won't take that money and spend it. Rather, they'll use it to pay down their credit cards or simply stash it in savings -- that's what most people did with the $300-to-$600 rebate checks they received a year ago. "That's not going to turn this economy around," says Gary Bass, executive director of OMB Watch, a nonprofit group that keeps tabs on the federal government's Office of Management and Budget.

Such one-time bonanzas rarely have any impact on the economy, but a long-term tax cut should, right? Maybe. But the issue there is that there are no long-term tax cuts in this plan. And the shorter the life of the tax break, the less of an impact it will have on the economy and markets.

"The further you put out the expiration of a tax break, the more it will affect behavior," Cusser says. "Behavior won't really change unless it's permanent."

(Yesterday, the stock market appeared to take some comfort in the fact that any tax relief was passed, and the major indices all finished higher.)

But to really effect any sort of change, tax cuts need to be permanent. "If we're going to do it, let's do it," Bass says. "If they want to increase the child tax credit -- which is a good idea -- let's have it as a permanent long-term tax cut."

There will likely be some change in investing behavior on the margins, though. Because the dividend tax cut will be in place through 2008, investors with a short (five-year) horizon might make some different decisions. And that might be bad for municipal bonds, Cusser says.

Local governments issue muni bonds to finance various programs and projects. Muni bonds are attractive for their tax-free yield but rarely trade above par value. With the dividend cut, dividend-paying stocks will become slightly more attractive, and given that there's also more potential for upside on the sale of the stock, investors may see a similar after-tax return with dividend-paying stocks as they do in their muni portfolio.

"Munis will see real competition from dividend-paying stocks," Cusser says. "This tax cut will hurt the muni market more than it helps the economy."