Symposium

0 Comments | Insight on the News, Nov 19, 2001 | by Tom Giovanetti, | William Gale, | Peter Orszag

Q: Should the economic stimulus package contain permanent tax cuts?

YES: Cutting marginal tax rates will ensure economic growth in the long term.

Businesses contract and people lose their jobs for a variety of reasons, but when businesses contract and people lose their jobs because of poor public policy the government has an obligation to do something about it. And, make no mistake about it, the current economic slowdown is the result of poor public policy, particularly poor tax policy.

To answer the question of whether the economic-stimulus package should contain temporary or permanent provisions, it is vital to understand the cause of the current economic slowdown.

The argument that a stimulus bill should contain only temporary provisions is based on the assumption that the economy is fundamentally sound, that there is nothing wrong with federal policy and that the current slowdown is simply a blip on the radar screen. But that assertion ignores the recent economic evidence regarding saving and investment and fails to explain why successive interest-rate reductions have failed to produce the expected impact on the economy.

First, it is clear that the current economic slowdown is not a result of the Sept. 11 terrorist attacks. Rather, the slowdown is the result of declining investment because of the current excessively high tax burden on capital, a result of the tax increases in 1990 and 1993 and exacerbated by income-tax bracket creep. Also contributing to the slowdown has been the misguided policy of both political parties that wealth is more productive in the hands of government (in the form of budget surpluses) than in the private economy.

As is widely understood, our economy is driven by investment. The availability of investment capital leads to new business creation and expansion, investment in new plants and equipment and the hiring of new employees. A recent study by economists Dale Jorgenson and Kevin Stiroh finds that the most important factor in worker productivity is not technology but the availability of capital.

Unfortunately, today's tax policy discourages capital formation. According to a study just released by the Institute for Policy Innovation (IPI), tax policy is devastating investors and entrepreneurs, who are paying an average of 62.5 percent out of every additional dollar earned on new investment in taxes to federal, state and local governments. This is by far the highest marginal tax rate on capital in recent memory. Is it any wonder that, with an effective marginal tax rate of 62.5 percent, investment has slowed?

And investment has slowed -- dramatically. Since early 2000, there has been a drop-off of investment in equipment. As a result, the economy grew at an anemic 0.8 percent for the first half of 2001, and output in the business sector declined 0.2 percent in the second quarter.

However, before people or businesses can invest, they must first save. And according to a recent study for IPI by economist Stephen Entin, in early 2000 the personal saving rate was nearly zero, a decline from about 9 percent in the mid-1980s. In fact, the saving rate was still about 2.5 percent in 1999, just one year earlier.

The fact is that tax policy in recent years has discouraged personal saving and punished investment. Thus, government has taxed away the savings of American workers and enriched its own coffers in the form of accumulated budget surpluses. The predictable result has been an economic slowdown. When did we decide that public policy should be to fatten the savings account of the federal government at the expense of the savings accounts of Americans?

In fact, it appears that only government is doing well in the current economy. If you take government spending out of the equation, the private economy has been in recession for some time. Just the other day it was announced that manufacturing activity had declined for the 14th straight month. Something must be done and it must be something permanent and structural, not simply an attempt to patch the economy with temporary measures.

You may be asking, "But didn't we just do this? Didn't we just pass a massive tax cut earlier in 2001 designed to redress these problems?" Indeed, presidential candidate George W. Bush recognized that the tax burden is excessively large and harmful to the economy and addressed the problem by making a large tax cut the centerpiece of his candidacy and the first major initiative of his presidency. Even that tax cut was too small, representing only a 3 percent reduction in the $44.4 trillion the federal government expects to collect over the next 10 years.

Unfortunately, by the time the legislative process got finished with his proposal, most of the truly potent aspects of the tax cut -- the proposals that would stimulate additional saving and investment -- were delayed years into the future. More than 60 percent of the tax cut will not occur until after 2005. Only 5.5 percent of it, or $73.8 billion, was slated for the current fiscal year, and most of that was the ill-designed tax rebate, a solution that attacked the wrong problem.