"Tax cuts work by increasing the incentives for new investment, not by stimulating demand."
Tax policy in the United States acts like a pogo stick. Since 1976, eleven major pieces of tax legislation have moved marginal personal tax rates up or down. The capital gains tax rate has been changed six times. In addition, there have been other targeted tax changes for depreciation and investment tax credits.
Countless accountants and lawyers spend their lives following these changes for the benefit of their clients. Despite all of this, there is deep disagreement on how tax changes affect the economy as a whole.
In the early 1980s, President Reagan cut taxes to "get the economy moving again," but George H. W. Bush, called Reagan's tax cut—"Voodoo Economics." In the early 2000s, this debate is taking place all over again. Some believe that President George W. Bush's 2003 tax cuts will stimulate growth. Others think they will ruin the economy. This isn't "just politics." Both sides find economic theory to back up their views.
Those who want to cut tax rates find support in the supply-side school of economics. The real intellectual firepower beneath the supply-side school comes from the Austrian economists, Ludwig von Mises and Friedrich Hayek. They believed that wealth creation starts with entrepreneurial activity—new ideas for goods or services, new and more efficient production techniques and new technologies. Lower tax rates stimulate this activity by increasing incentives for saving, investment, risk taking, and work effort.
Those who oppose these supply-side tax cuts follow the teachings of John Maynard Keynes. Keynes earned his stripes in the Great Depression, when he said that consumers saved too much, and did not spend. Therefore, the government should spend and run a federal budget deficit. Keynes argued that demand-side stimulus, not supply-side stimulus is what an economy needs when it is down.
Support for this theory has waned; deficits are now viewed as hurting the economy because they supposedly drive up interest rates. Still, when the political winds are strong to do something to help the economy, even Keynesians propose tax cuts. However, what they propose is tax rebates, especially for low-income earners, to stimulate consumer demand. The idea is that low-income earners spend more of any tax rebate, while higher income earners save more. Keynesians want to stimulate demand.
Cutting through all this confusion is difficult, and sometimes it seems like everyone is talking Voodoo. As a result, many myths about tax cuts are repeated time and time again in our nation's press. Let's take a look at some of those myths.
Myth #1—Deficits Drive Up Interest Rates
This myth is probably repeated more than any other, and is even perpetuated by Alan Greenspan. But history shows that it is not true. The facts speak for themselves. Despite 10 consecutive years of deficits between 1982 and 1992, and a large increase in the national debt, 30-year mortgage rates fell from 18% to 8%.
Between 1992 and 2000, deficits disappeared and surpluses took their place. Mortgage rates, however, hardly budged. In late 2000, despite the largest annual surplus in U.S. history, 30-year mortgage rates were still 8%, the same level as 1992.
Since then, because of recession, terrorist attacks, war, and tax cuts, the federal budget is back in deficit again. But 30-year mortgage rates fell to 45-year lows of just over 5%. For the past 21 years, deficits and interest rates have moved in opposite directions. As deficits have grown, interest rates have fallen.
The theory suggests that deficits "crowd out" private investment, putting upward pressure on interest rates. In other words, government borrowing eats up the available pool of capital. But today's forecasted deficits of $300 to $500 billion are just a small drop in the pool of global capital markets. In the U.S. alone, capital markets are $30 trillion dollars deep, for the world as a whole they approach $100 trillion. Deficits of the size projected in the years ahead cannot possibly have the impact on interest rates that many fear.
But even this is not enough to stop some who believe in "crowding out." They argue for tax hikes to balance the budget, so that interest rates will fall. The flaw in this theory is that taxes also remove money from the private sector. If taxes were raised to balance the budget, the same amount of resources would still be "crowded out."
For further discussion of taxes, interest rates, and crowding out, see "Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence," by Morgan Rose; and "Fiscal Policy," by David N. Weil, and "Reaganomics," by William A. Niskanen in the CEE.
Spending, not deficits, "crowd out" investment. Spending must be financed by either borrowing or taxation. Borrowing is voluntary: taxation is not. So, if war, or other special circumstances exist, borrowing is always the least intrusive way to finance the increased spending. If the economy is in recession, tax cuts should be used to boost the economy. Arguing against tax cuts because they will supposedly boost interest rates is disingenuous—on both theoretical grounds and historical evidence.
Myth #2—What matters is "putting money in people's pockets."
Many economic models judge the power of a tax cut by how much and how fast money ends up in the hands of consumers. President Bush said as much when he signed his 2003 tax bill into law: "When people have more money, they can spend it on goods and services. And in our society, when they demand an additional good or a service, somebody will produce the good or a service. And when somebody produces that good or a service, it means somebody is more likely to be able to find a job."
Unfortunately, while this sounds good, it is wrong. Tax cuts do not work by putting money in people's pockets. If they did, then just having government give money to people could guarantee growth. But taxing or borrowing money from one group, to give it to another, does not encourage productive economic activity.
If the government gave a $1000 rebate to every family in America, potential new spending would be roughly $100 billion. This is less than 1% of GDP, a very small impact. But more importantly, corporate executives would never authorize the building of new stores or factories for this one-time event. The impact would be very short-lived.
In addition, consumers are not as dumb as they seem. A tax rebate must come from somewhere. If the government borrowed money to pay the rebate, then taxes would eventually be raised to pay it back. As a result, any rebate would be viewed, not as a permanent change in after-tax income, but as a temporary loan. Surveys show that consumers spent just 25% of the 2001 tax rebate. The other 75% was either saved or used to pay down debt.
Tax cuts work by increasing the incentives for new investment, not by stimulating demand. In the early 1980s, despite large tax cuts, consumers were not banging down the doors of local retailers for fax machines, cell phones, PCs, or broadband Internet connections. It was only after some very smart entrepreneurs decided to risk a great deal of money, time and talent developing these new goods and services that they became so ubiquitous. By cutting taxes on income and capital gains in the early 1980s, Ronald Reagan encouraged these entrepreneurs to take the risks necessary to develop these new technologies. To paraphrase Say's Law: Supply created its own demand.
Incentives are what matter, not pocket money. In 1997, President Clinton cut the capital gains tax rate from 28% to 20%. This meant that the after-tax return from a $100 capital gain increased from $72 to $80—an 11% increase. This 11% increase in incentives led to the late 1990s boom in stock prices, venture capital investment and innovation.
For the same capital gain, the 2003 Bush tax cut will increase after-tax returns by 6.6% (from $80 to $85) and for dividends by more than 30% (from $62 to $85). These changes will reduce the cost of capital, encourage more investment and savings, and cause more companies to pay dividends. The end result will be an increase in economic growth, rising stock prices and a rebound in venture capital investment.
Myth #3—A Sunset Tax Cut Will Not Change Behavior
In order to fit the 2003 Bush Tax Cut under an artificial $350 billion dollar ceiling, the U.S. Senate cut the capital gains and dividend tax rates for just 4½ years. After 2008, these rates will return to their pre-tax cut levels. Some suggest that these sunset provisions eliminate any beneficial impact on investment incentives.
But by looking at this from another perspective, we can see than this claim is not true. Imagine if in the middle of a baseball game the umpires decided that for the next three innings, each homerun would count as three runs on the scoreboard. Every player would start swinging for the fences and every manager would encourage it, despite the fact that the change was temporary. Moreover, the average score of each game would go up.
The same is true for sunset provisions of the tax code. Investors and corporations will change their behavior. Entrepreneurs, investors and business leaders will increase risk-taking for the time frame of the tax cut and asset values will rise. When this occurs, only suicidal politicians would vote to repeal the tax cut. Imagine the fans reaction if the NBA and the NCAA decided to get rid of the three-point play in basketball.
Nonetheless, there will still be some entrepreneurs and investors who will be hesitant to assume business risks that take more than 4½ years to come to fruition—even if there is a good chance the tax cut will be made permanent. A permanent tax cut, because it avoids this problem, is always better than a temporary one. However, a sunset tax cut will still have a positive impact on decision-making.
Myth #4—It's Size That Matters
Most mainstream economic models estimate the effect of a tax cut by its size—the bigger the better. This approach is an offshoot of the "putting money in people's pockets" theory. However, this analysis is overly simplified. Tax cuts should be measured, not be their size, but by how they alter behavior.
In 1997, the Clinton capital gains tax rate reduction was estimated to "cost" just $3.3 billion over five years. By any measure of absolute size, this was small. But its impact was huge. Venture capital investment soared by 400 percent and the stock market expanded at an annual average of over 20% for five consecutive years.
Another provision of the 1997 tax legislation was to change the capital gains tax rate on profits from the sale of a principal residence. Before the new law, individuals were allowed a single tax-free gain of only $125,000 after the age of 55 and homeowners were forced to roll over any gains into a new home until they decided to use the exemption.
The new law allowed couples to take up to $500,000 in tax-free gains after living in their home for just two years. The total cost to the government was estimated to be between $1 and $1.5 billion over five years. However, when this law passed in mid-1997, housing became the least-taxed investment in America. The result was a boom in housing that has lasted to this day.
During the recession of 2001, new housing starts and housing sales rose for the first time in any recession, ever. In fact, many economists credit the housing market for keeping the economy growing during recent years. The size of any tax cut, measured as "foregone" revenue to the Treasury, is not an appropriate measure of its economic impact.
Myth #5—We Fixed Bracket Creep
Tax brackets in the 1970s were not indexed for inflation. As a result, inflationary wage gains pushed more and more taxpayers into higher and higher tax brackets. The effect was an increase in tax rates and a reduction in economic growth rates without any legislation. Starting in 1984, however, tax brackets were indexed for inflation.
While many people think this has fixed this problem, they are mistaken. Tax brackets should also be indexed for real income gains. If tax brackets were never changed, over the next century, real income gains would push every American into the top tax bracket, even those with the lowest income.
In 1998, 5.1 million tax returns were filed for taxpayers in the three highest tax brackets (31%, 36% and 39.6%). By 2000, the total number of returns filed at these marginal rates had climbed to 6.4 million, a 25% increase. As productivity increases, real wages grow faster than inflation. And the problem becomes worse in times of great prosperity.
As more and more taxpayers were pushed into these higher brackets, average effective tax rates increased even though no new tax legislation was proposed. These inadvertent tax hikes punished success and undermined economic growth. The recession of 2001 was at least partially caused by these tax hikes. To fix real bracket creep permanently, tax brackets should be adjusted for real income gains, or tax rates should be cut slightly each year.
These five myths about taxes, and their impact on the economy, expose just a few of the problems with the conventional analysis of fiscal policy. Taxes have a profound impact on the economy, but often not in the way that we read about in the papers.