THIS TIME LAST YEAR many conservatives wondered aloud whether George W. Bush was genuinely committed to his own tax cut proposal. Now it seems that Bush is the only supply-side tax cutter left in town. He has been heroically unwavering in support of the $ 1.3 trillion tax cut, but the media, many mainstream economists, and congressional leaders in both parties are urging a go-slow approach. Speaker of the House Denny Hastert has suggested to Bush that he divide his tax cut up into small digestible pieces, a compromise that could undermine the chances of the crucial income tax rate cut. Bob Dole has advised that Bush’s tax cut be put “on hold.” Meanwhile, on Face the Nation, Senate minority leader Tom Daschle moaned: “I can’t think of anything that would divide the nation more than pushing that tax cut at that size.”
Bush has smartly countered that the slowdown of the economy, the bearish stock market, and the specter of a looming recession only strengthen the case for tax rate cuts. Ironically, six months ago the Clinton Treasury department and other Bush opponents were arguing that a Bush tax cut was inadvisable because it could cause the roaring economy to “over-heat.” Of course, that worry’s now the least of our problems, but the tax cut foes are as opposed as ever to the Bush proposal. The latest mantra against tax cuts is that they are ineffective at stimulating the economy. The Washington Post, for example, recently editorialized that “the best tool for managing the economic cycle is usually not fiscal policy, but interest rates, which the Fed can change at its annual meeting.”
Yikes! This advice is so wrong-headed that it needs to be thoroughly expunged before it begins to steer the economy further off track. So let us try to explain why Bush is right on taxes, and his critics aren’t.
First, we should all agree that the U.S. economy does need some anti-recession insurance right now. Just since the election, roughly $ 1 trillion of wealth has disappeared through sliding stock values. The Gross Domestic Product growth rate was a robust 5 percent in 1999; now it’s an underwhelming 2 percent. Retailers felt the pinch during the Christmas shopping season; it’s going to get worse in the first half of 2001. And if the economy does hit a recession, low-income and working-class Americans will be the ones hurt most, not the rich people whom tax cuts supposedly benefit.
There’s some persuasive evidence that the economy is suffering from tax drag. Fiscal policy is way too tight. In 2000, federal, state, and local governments collected a combined $ 300 billion in excess taxes over spending. That’s almost 4 percent of GDP devoted to tax overpayments. Over the course of the past 30 years, a tax-to-GDP ratio of more than 20 percent has typically sounded a Code Blue warning of recession. Since 1995 the tax-to-GDP ratio has risen from 18 percent to about 21.5 percent. Amazingly, today’s tax burden is higher than that of the stagflationary Carter years. This fiscal anchor needs to be lifted.
So we have a record tax burden, a huge budget surplus, and the near-term horizon shows the potential for an economic crash. If a supply-side tax rate reduction isn’t advisable now, just when is the appropriate time to cut tax rates? Even left-leaning Keynesians should be agitating for a tax cut now. Where are they when we need them?
We would note that in the past 18 months many of our major economic competitors — including France, Germany, and Japan — have lowered income taxes to jump-start their stagnant economies. Because we have done nothing to chop our own taxes, our international competitive tax advantage has deteriorated.
The alternative economic rescue plan, supported by many Wall Street economists and almost everyone in the media, is to continue to use the Federal Reserve Board to stimulate the economy. This approach is dangerously misguided. If there is a single enduring economic lesson of the past 25 years, it is that loose monetary policy can never offset the contractionary effects of high taxes. Loose money and high taxes were the ill-designed formula of the 1970s that led to high inflation, low growth rates, and a yawning bear market.
Nonetheless, we were pleased with the Fed rate cut in early January. Loosening monetary policy makes sense because inflation is under wraps. Gold prices are near their record low. The dollar remains strong. Prices for many consumer goods, such as autos and textiles, are falling. (Remember: The Consumer Price Index overstates inflation by 1 to 2 percentage points.) Interest rates are falling. But here’s the key point: The case for continued monetary loosening can only be justified by evidence that we may be close to a deflationary monetary regime, not by the fact that the economy is losing steam. The Fed’s job is to achieve price stability, pure and simple.
Printing more money doesn’t produce real economic growth. Doing so will not prop up the stock market for long, as many Wall Streeters discovered after the January rate cut. Printing money can, however, produce inflation. Deviating from a stable price structure, whether through inflation or deflation, always hurts long-term economic growth. Price stability is also significant to boosting asset values. One of the reasons the Dow Jones has risen from 800 in 1982 to 10,500 today, is that inflation has been gradually sweated out of the economy from a high of 11 percent in 1979 to the 2- to 3-percent range today.
Clearly, if 16 years of falling inflation has been bullish for capital markets, it is a non sequitur to argue that rising inflation will also be bullish. It’s hard to see how a loose monetary policy could be expected to cause a rally in the sagging technology stocks, for example. In the long term, the consequence of accommodating a little more inflation is a little less economic growth.
It is a mistake to think the best tool for managing the economic cycle is Fed interest rate policy changes. The Washington Post offers bad advice when, in an editorial, it says, “The Fed can cut rates quickly to boost growth and then move them up again when the economy recovers.” Alan Greenspan and the Fed do not control interest rates in the economy. In terms of the U.S. capital market the Fed is not a very large borrower or lender and interest rates are simply the prices that clear the debt markets. There is a persuasive body of economic evidence indicating that Fed rate changes follow the market, not lead it.
Which brings us back to the fiscal side of the equation. What is needed to stave off a slowdown is a supply-side tax rate reduction that raises the after-tax rate of return on capital, creating incentives for production here in the United States. The defect of the Bush tax cut is that it may be too small and the rate cuts too insignificant to provide the supply-side boost needed. The Bush plan would lower the top tax rate from 39.6 percent to 33 percent, but only over several years. The $ 1.3 trillion price tag only seems enormous. The total tax revenue stream will approach $ 25 trillion, and the surplus is expected to be $ 4 trillion. In fact, the Bush tax plan is less than half as generous as the Reagan ’81 tax cut.
What’s needed is a plan to grow the Bush tax cut, not shrink or delay it. The 1997 capital gains tax cut had nothing but positive effects — a bullish rally in the markets, increased foreign capital investment in the United States, a huge rise in venture capital investing, and a surge of tax payments by the wealthy. That successful policy should be followed up with another capital gains rate reduction from the current 20 percent rate to 10 percent or 15 percent. (This would instantly revive the Nasdaq.) The Bush White House should also propose an expansion of IRAs to reduce the tax bias against savings. The ultimate goal should be unlimited IRAs.
All of these pro-saving, pro-investment tax cuts should be made retroactive to January 1, 2001. This would ensure that the stimulus would occur almost immediately. And if the tax package is split up, the Bush team should take the advice of representative Pat Toomey of Pennsylvania, who has proposed that income tax rate cuts come first.
One last point. Some economists, such as former Clinton chief economic adviser Laura Tyson, are complaining that the Bush tax cut should be scuttled because it cannot be implemented in time to rescue the economy from a recession. But there’s no reason Bush’s plan couldn’t be enacted in the first 100 days of his administration.
Back in the 1970s, the United States mistakenly tried to offset the negative impact of rising tax rates with easy money. We learned that you can’t tax or inflate your way to prosperity. The proper response to a slowing economy is falling tax rates and tight money. That is precisely the opposite of what too many pundits and politicians want. Let’s hope Bush continues to ignore them.
STEPHEN MOORE;Arthur Laffer is president of Laffer Associates in San Diego, California, and Stephen Moore is a senior fellow at the Cato Institute in Washington, D.C.
