The Freep Opinion Columnists
Home News Sports Entertainment Money Features Opinion Community Services Marketplace

SERVICES
MARKETPLACE

Local comment: Tax cuts aren't economic cure-alls

February 12, 2001

LOCAL COMMENT

BY MATTHEW SHAPIRO
and JOEL SLEMROD

PRESIDENT GEORGE W. BUSH has proposed a tax cut amounting to $1.6 trillion over 10 years. During the election campaign, the central justification for a tax cut was the beneficial incentive effects of lower tax rates -- how it lowered the tollgate to the middle class. Chief Bush economic adviser Lawrence Lindsey also argued that a tax cut would serve as insurance against a recession.

The future may have arrived more quickly than Lindsey anticipated. Economic growth slowed during the second half of 2000. The consensus of private forecasters has the economy weak in the first half of this year, leading to a modest increase in unemployment. Few economists, however, are forecasting a recession. Most expect the pace of growth to increase in the second half of 2001.

Nonetheless, Bush is using this modest slowdown as an argument for his tax cut plan, to stimulate and stabilize the economy.

Nine years ago, the first President George Bush proposed a package of fiscal measures that also were designed to stimulate the economy. One element of this package, and the only one that went into effect, was a reduction in income tax withholding during 1992. The rationale for this policy was that households would spend this extra take-home pay and hence stimulate output in the less-than-fully-employed economy, even though any increase would be offset by a lower tax refund in 1993.

Did it work? To investigate this question, soon after the change took effect we surveyed 500 taxpayers. We found that about 40 percent said they were spending the extra take-home pay, suggesting that the program would be moderately effective in stimulating consumption.

To our surprise, though, we found no clear relationship between income level and the tendency to spend the extra income. This evidence suggested that even a retiming of one year's tax collections could induce at least a short-term stimulative effect. But the survey implied that the program added no more than $11 billion, or only 0.2 percent of gross domestic product, of spending to the economy -- not enough to boost the feeble growth that contributed to Bush's defeat in 1992.

The current president proposed during his campaign that his tax cuts not take effect until 2002. Now President Bush is suggesting that the tax cuts be made retroactive to the beginning of 2001. Once enacted, the withholding tables would be adjusted and individuals could receive an immediate rebate check to reflect their excess withholding during the year to date.

Our survey concerning the elder Bush's scheme suggests that a rebate and a change in withholding would indeed generate more private spending.

Nonetheless, there are good reasons not to rely on tax policy to even out blips in the economy.

First, even if consumers respond instantaneously to extra take-home pay, the delay in implementing tax changes makes them an ineffective answer to short-term fluctuations in aggregate spending.

Second, adjusting tax rates to respond to current economic conditions contradicts the sound principle that tax policy should aim for long-run fiscal balance with a minimum of distortions on private activity.

Finally, most economists now agree that monetary policy should be, and is, the main instrument of stabilization. If a tax cut stimulates the economy more than the Fed feels is warranted, it will respond by cutting interest rates less than it would in the absence of a tax cut.

Recall President Bill Clinton's first State of the Union address in February of 1993. Although he campaigned on a platform of tax cuts, by the time of the speech he had come around to thinking that a more appropriate strategy would be to raise taxes. By impressing on the bond market that his administration was committed to fiscal prudence, he hoped that the resulting lower interest rates would be a stimulus to growth.

The initial Clinton plan did include some modest public investment initiatives to provide short-run stimulus, but these were quickly abandoned. The economy has been healthy ever since.

The first Clinton State of the Union address provided a powerful visual symbol of the link between fiscal and monetary policy. Sitting next to Hillary Clinton in the House gallery was none other than Federal Reserve Chairman Alan Greenspan. The Clinton administration clearly got the message that if it pursued a prudent fiscal policy with an aim of long-term deficit reduction, the Fed would pursue a monetary policy aimed at maintaining low inflation and full employment.

Of course, times and budget projections have changed, and Greenspan has now testified that he favors a tax cut based on his long-run assessment of the federal budget. Nevertheless, he has made clear that he feels that stabilization of the economy should be left to monetary policy. The administration would be well advised to heed this message.

MATTHEW SHAPIRO and JOEL SLEMROD are professors of economics at the University of Michigan. Write to them in care of the Free Press Editorial Page, 600 W. Fort St., Detroit, MI 48226.

MORE COLUMNS

FREEP FRONT | VOICES FRONT

Comments? Questions? You can reach us at The Freep
Home News Sports Entertainment Money Features Opinion Community Services Marketplace

All content copyright 2001 Detroit Free Press and may not be republished without permission.