The economic case for a tax cut seems compelling. The U.S. economy is unwinding from an unstable boom. “Animal spirits”–the immortal phrase of economist John Maynard Keynes–took hold. Consumers overborrowed or, dazzled by rising stock prices, overspent. Businesses overinvested thanks to strong profits and cheap capital. Both consumers and businesses will now curb spending: consumers made cautious by high debts, stagnant (or falling) stocks and fewer new jobs; businesses deterred by surplus capacity and scarcer capital. A tax cut would cushion the spending slowdown.
Consumer spending (68 percent of gross domestic product) and business investment (14 percent) constitute four-fifths of the economy. If they are in retreat, the economy is in trouble. (Housing, exports and government represent the rest.) The case against a tax cut is that the spending slowdown will be mild; it will be checked by the Federal Reserve’s cut in interest rates. Perhaps. But if businesses have idle capacity and consumers have excess debts, lower interest rates may not stimulate much new borrowing.
Nor will large budget surpluses automatically preserve prosperity. This argument is absurd. The surpluses are the consequence–not the cause–of the economic boom and stock market frenzy, which created a tidal wave of new tax revenues. But now surpluses may depress the economy by removing purchasing power.
This is easy to grasp. Suppose the budget surplus were $1 trillion or about 10 percent of gross domestic product. Would anyone deny the drag on economic growth? This drag could be offset only if the resulting drop in interest rates and repayment of federal debt created an equal stimulus. Though conceivable, this seems unlikely. Today’s surplus is only $200 billion to $300 billion, or about 2 percent to 3 percent of GDP. But the same reasoning applies. The surplus doesn’t mechanically create demand or spending, and probably does the opposite.
A year ago, a tax cut would have been folly. Private spending was booming. But a tax cut now is not an effort to “fine tune” the economy. It’s the logical response to the end of the private boom–an attempt to prevent a “bust” by restoring some of people’s incomes. Whose incomes? Who deserves tax cuts? These are the harder questions.
President Bush’s across-the-board rate cuts would give the largest dollar tax cuts to the wealthiest Americans, because they pay most taxes. In 2000, the richest 10 percent of Americans–whose incomes begin at $100,000–paid 66 percent of the federal income tax and 50 percent of all federal personal taxes (including payroll and excise taxes), estimates the Congressional Joint Committee on Taxation. In 1977, the richest 10 percent paid only 50 percent of income taxes and 43 percent of all federal taxes. There are two reasons for this trend: (a) the rich’s incomes grew faster than everyone else’s; and (b) tax relief went more toward the lower half of the income spectrum.
If you like income redistribution for its own sake, this is wonderful. But the growing gap between those who pay for government and those who receive its benefits creates a dangerous temptation. It is to tax the few and distribute to the many.
As originally proposed, Bush’s plan was avowedly political. It aimed to restrain government spending by depriving government of some money to spend. But Bush is now selling his program as an antidote to economic slump. Ironically, this strengthens the case for skewing the tax cut toward middle- and lower-income households. Almost certainly, their debt burdens are higher than upscale America’s. They may also spend more of any tax cut than the rich, providing greater support to the economy.
Finally, it’s true that an excessive tax cut would invite future deficits. How to balance these competing pressures is what we will debate. My preference is to accelerate the introduction of Bush’s across-the-board rate cuts, with one exception; I would cut the top rate of 39.6 percent to 35 percent, instead of Bush’s 33 percent, and use the savings to broaden tax cuts at lower income levels. I would also accelerate the increase in the child tax credit–from $500 to $1,000–but defer Bush’s other proposals (ending the estate tax, bigger charitable deductions). This would raise the overall tax cut’s immediate economic impact and reduce the long-term budget costs.
As we debate, we should not idealize budget surpluses. They are paper projections. If the growth doesn’t materialize, neither will the surpluses. A slavish effort to preserve the surpluses could perversely destroy them.
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