Will the tax cut work?

Will the tax cut work?

Will the tax cut work?

The search for better economic policy.
June 10 2003 10:24 AM

Will the Tax Cut Work?

Here's how we'll know if it does.

Economics is usually unable to do the one thing most non-economists expect it to: predict the future. Economic theory provides a decent guide to what's likely to happen, but when government undertakes big policy changes, such as this year's tax act, there are always too many variables to predict the economic outcome in any detail or with much confidence.

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Presidents take their chances, anyway. The first President Bush raised taxes and cut spending in 1990, hoping it would produce strong growth in 1992. It didn't. President Clinton tried the same approach in 1993, and it worked spectacularly. Mainstream economics supported them both, but conditions wholly independent of their deficit reduction efforts—corporate debt levels, the price of computing power, and so on—led businesses to respond to lower deficits in the mid-'90s in ways they didn't a few years earlier.

So it's impossible to forecast the results of President Bush's tax cut today, and it will still be hard a year from now, during his re-election campaign. But next year, President Bush and his Democratic opponent will both insist that voters rush to just such a judgment. How will we know if the tax cut is working?

Ronald Reagan's famous formulation—are you better off now than you were four years ago?—won't help much. In fact, Americans were considerably better off in 1980 than they were in 1976; but they were worse off than they had been in 1979, and that's what mattered. Since economic growth is the norm, by this standard any policy change that's not followed by a recession or galloping inflation (or deflation) in an election year would be judged a success.

The question the administration would probably like voters to ask next year is whether they're better off than they were before the tax act passed. Phrasing it that way tacitly writes off Bush's first two-and-a-half years of slow growth and high unemployment. And it takes advantage of the fact that most economists expect the economy to perk up by autumn, regardless of tax changes. For example, the Congressional Budget Office months ago saw GDP growth quickening from 2.5 percent this year to a respectable 3.6 percent in 2004. So no matter what, voters are likely to be better off in November 2004 than they are now, even if the tax cuts have nothing to do with it.

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The better question about the tax cuts is: Will they enable the economy to grow noticeably faster than the expected 3.6 percent next year? That could be tough: The CBO found that the president's original tax proposals—more far-reaching than those finally approved—would have scant impact on 2004 growth. The changes that passed are just very small in an $11 trillion economy—$49 billion this year and $135 billion in 2004. Still, if growth surpasses 3.6 percent, the president's supporters will credit it to his tax policy.

You can also measure the success of the tax act against the claims its proponents have made for it. Politicians typically overstate and oversell their proposals, so the administration probably does not want people to think about the cut this way. For example, the president has said that 91 million taxpayers will get an average tax cut of $1,126 this year. But averages are deceiving when a small share of the people receives most of the benefits. In this case, the 83 percent of American households will get less than that average—including 50 million households that receive no tax relief at all and another 24 million that can expect $100 or less—could judge it a failure, or at least a disappointment. The administration has also promised that the changes will create jobs, because 2 million small business owners receive an "average tax cut" of $2,209 this year. Again, 83 percent of those with small-business income will receive much less—including more than one-third who get less than $100—providing scant incentive or means to create jobs.

The act clearly will deliver, as promised, lower taxes for high-income people—with a 35 percent top rate and the new 15 percent rate on dividends and capital gains. But how to judge Bush's claim that those lower taxes will help jump-start business investment? Business investment could certainly use a boost—it fell almost 5 percent in the first quarter of this year—and the act includes another provision to help it along: An 18-month, immediate, 50 percent depreciation bonus for business investments. Yet all these tax cuts may not make much difference, so long as the problem is slow demand. Why invest more, when one-quarter of industrial and commercial capacity is already idle because of slack demand? The test for these provisions will be whether business investment revives despite all that unused capacity. If it does, score one for President Bush.

The tax cut on dividends and capital gains comes with another promise and another test: the claim that it will boost the stock market and therefore wealth, which in turn will raise spending by both individuals and businesses. The catch here is that so long as corporate profits remain low, lower taxes on those profits will have little effect on stock prices. Yet by most historical standards, a market upturn is long overdue, and the proponents speak of a mere 5 percent upswing in stock prices. The right test here is whether the stock market rises more than it would have without this tax cut, but that's something that economists have no way of knowing. (The more troubling question: Why is a conservative administration trying to manage stock prices at all, a form of government intervention that liberal administrations have never contemplated?)

Another way to judge the tax cuts is by their actual costs.  Fiscal discipline has become a relative concept, but Senate proponents of the tax cuts did insist that the act cost no more than $350 billion over 10 years. House Republicans went along, grudgingly, by imposing a number of sunset provisions: The child credit increase, marriage penalty provisions, and 50 percent bonus depreciation all expire or phase down at the end of 2004; and the lower tax rates on dividends and capital gains expire in 2009.  By doing that, they focused the stimulus on the first two years and limited the long-term costs—just what economics recommends when growth is stalled but expected to pick up down the road.  If these sunsets are removed, as most politicians expect they will be, the price tag will balloon to nearly $1 trillion, not counting a few hundred billion dollars more in additional interest costs, and the act's economic rationale will be shredded.

Even at $350 billion, the econometric model used by the president's Council of Economic Advisers projects that the policy will slow growth five years out, as higher deficits crowd out private investment. The CBO reached the same conclusion. If the act increases deficits by another $1 trillion, every economic model and all economic experience say that long-term investment, productivity, incomes, and growth all will slow measurably.  And that doesn't include the implicit "opportunity costs." Using $1 trillion for these tax cuts denies us the opportunity to deploy those resources in ways that could produce larger benefits—for example, defraying tuition costs for every college-bound young American, or saving the $1 trillion for the Social Security and Medicare bills looming round the corner.

Whatever the long-term costs, the dilemma for opponents of the policy is that in the short run, tax cuts leave nobody worse off—not even the low-income families locked out of the higher child credit—and lots of people get a little more post-tax income. President Bush only has to make the tax cut look good until November 2004. The rest of us will have to bear it for years.