In June of 2001, President Bush signed a tax reduction plan of
$1.35 trillion spread over ten years. The White House has recently
proposed to speed up the implementation of this plan and introduce
a number of additional provisions. The reason for this activity is
that the unemployment figures have been looking remarkably grim in
recent months, 6 percent in December.
This is not high by historical standards (unemployment was
between 8 and 10 percent for all of the 1980s) but most economists
agree that it is higher than the current sustainable or
“natural” rate of unemployment. The economy is not
pulling out of the most recent recession as fast as had been
predicted.
Most recessions in the postwar period have lasted for less than
eight quarters. In the event of a recession there are two questions
we should ask. Can the government do anything to alleviate the
recession? Should the government do anything to alleviate the
recession? Most economists think the answer to the first question
is yes. Opinions on the second question are divided.
A good deal of criticism of the Bush plan has focused on the
fact that it will increase the deficit and raise the burden of tax
payments for future generations. But although we should be
concerned about keeping deficits low during periods of economic
growth, such as the 1980s expansion, it is not clear that low
deficits make sense during recessions.
For much of this century the government has been able to borrow
at an interest rate lower than the rate at which its revenues were
increasing due to the natural growth of the economy. As a
consequence of low interest rates, (with the exception of the two
world wars when deficits were high to finance short term military
expenditures) government debt as a percentage of the gross domestic
product has fallen every year from 1890 through 1980.
The government budget deficit only became a political issue in
the 1980s when the Federal Reserve Board raised the interest rate
to unprecedented levels in a successful attempt to control
inflation. As a consequence of high interest rates, the government
debt as a percentage of GDP began to climb until the Clinton
administration passed the Deficit Reduction Act in the early 1990s.
The debt to GDP ratio has been falling since the mid 1990s and is
currently equal to about 60 percent. The deficit is currently
around 1.5 percent of GDP. Both the debt and the deficit, (measured
as fractions of GDP) are relatively low by international standards,
and a deficit of 1.5 percent of GDP is not a large number during a
recession. Since the economy is likely to grow rapidly again once
the current recession ends, running a deficit at current levels is
not likely to be a long-term problem.
So where does this leave us with the Bush tax plan? Most
economists agree that some kind of economic stimulus is needed to
pull us through the current recession. There are two ways to
achieve this – monetary or fiscal policy. In a monetary stimulus,
the Federal Reserve Board lowers the interest rate thereby making
borrowing cheaper and pumping more money into the economy. In a
fiscal stimulus the Congress lowers taxes or increases government
spending. For the past twenty years, the United States has relied
predominantly on monetary policy to control recessions. This has
been remarkably effective, but the current scope for active
monetary policy is limited since the federal funds rate (the
overnight interest rate at which banks can borrow and lend to each
other) is already at 1.25 percent, lower than its been since
1950.
This leaves us with fiscal policy, and although most economists
and politicians agree that some kind of stimulus is required, the
precise nature of the required stimulus remains a hotly debated
issue. The Democrats are more inclined to favor an active role for
government in the economy. In the past they have favored increased
government spending. The downside of increased spending is that it
tends to be permanent. Governments rarely get smaller. Republicans
favor a tax cut as way to reduce the size of government. They are
aware that lower taxes will help put downward pressure on
government spending in the future.
The Bush tax reduction plan was signed into law in June 2001
““ it involved a $1.35 trillion tax cut spread over ten years.
Since the U.S. GDP is currently about $9.5 trillion, with the tax
cut spread over ten years, that’s approximately 1 percent of
GDP per year. The most recent initiative from the Republican camp
would push the relief forward by lowering taxes more immediately
instead of spreading the entire cut evenly over the entire ten-year
period. The reason for this proposal is that there have been lower
than expected gains in employment in the recent months, and the
economy is not pulling out of the recession as quickly as many
economists had been forecasting.
The Democrats are not opposed in principal to the idea of
cutting taxes ““ their biggest beef is with the distribution
of the relief among different groups of taxpayers. For example, one
of the proposals on the table is to eliminate the taxation of
dividend income on the grounds that it is currently taxed twice;
once when received as income by corporations and again when paid
out to shareholders. The Democrats do not like cuts of this kind
since, they argue that dividend income tax is paid mainly by the
rich. Sen. Kerry of Massachusetts, for example, argues that
“… the new tax cuts proposed by the president don’t
make economic sense, and they’re not fair.” Kerry
favors instead the elimination of the payroll tax which is more
regressive since it falls proportionately more heavily on
low-income workers.
Whatever ways the fiscal handout is divided, the bottom line is
that a tax cut at the current time is a good thing and is unlikely
to cause serious problems for future taxpayers. How we split the
pie, as always, depends on the political clout of different
interest groups. We would all be better off with a simpler tax
system ““ I personally favor a flat tax ““ but given the
way our political system is funded this is unlikely to occur any
time soon.