By now, it’s clear that most commentators missed the economy’s emerging weakness. Indeed, a recession may already have started. Industrial production has declined slightly since September. Christmas retail sales were miserable; at Wal-Mart, same-store sales were up a meager 0.3 percent from a year earlier. The story’s the same for autos; sales declined 8 percent in December. Montgomery Ward is going out of business. Last week’s surprise interest-rate cut by the Federal Reserve confirms the large miscalculation.
A tax cut is now common sense. It would make it easier for consumers to handle their heavy debts and, to some extent, bolster their purchasing power. The fact that President-elect George W. Bush supports a major tax cut is fortuitous. But his proposal is poorly designed to combat recession. Although the estimated costs–$1.3 trillion from 2001 to 2010–are large, they are “backloaded.” That is, the biggest tax cuts occur in the later years. In 2002, the tax cut would amount to $21 billion, a trivial 0.2 percent of gross domestic product (national income). This would barely affect the economy.
What Bush needs to do is accelerate the immediate benefits (to resist a slump) while limiting the long-term costs (to protect against new deficits). This would improve a tax plan’s economic impact and political appeal. The required surgery is easier than it sounds:
Bush’s across-the-board tax-rate cuts should be compressed into two years–making them retroactive to Jan. 1, 2001–instead of being phased in from 2002 to 2006. The idea is to increase people’s disposable incomes, quickly. (Under the campaign proposal, today’s rates of 39.6, 36, 31 and 28 percent would be reduced to 33 and 25 percent. The present 15 percent rate would remain, but a new 10 percent rate would be created on the first $6,000 of taxable income for singles and $12,000 for couples.) Similarly, the proposed increase in the child tax credit, from $500 to $1,000, should occur over two years, not four.
The distribution of the tax cut should be tilted more toward the bottom and less toward the top. One criticism of the original plan is that it’s skewed toward the richest taxpayers, who pay most of the taxes. (In 1998 the 1.6 percent of tax returns with incomes above $200,000 paid 40 percent of the income tax.) The criticism could–and should–be blunted by reducing the top rate to only 35 percent, while expanding tax cuts for the lower brackets. This would concentrate tax relief among middle-class families, whose debt burdens are highest.
Bush should defer most other proposals: the gradual phaseout of the estate tax, new tax breaks for charitable contributions and tax relief from the so-called marriage penalty. Together, these items would cost an estimated $400 billion from 2001 to 2010. They are the most politically charged parts of the package and the least related to stimulating the economy. Proposing them now would muddle what ought to be Bush’s central message: a middle-class tax cut to help the economy.
The case for this tax cut rests on a critical assumption. It is that the slowdown (or recession) could be long, deep or both. If it’s just a blip–as some economists think–the economic argument for a tax cut disappears. The economy will revive quickly, aided by the Fed’s lower interest rates. Then the debate over a tax cut should return to political preferences. Do we want more spending, lower taxes or debt reduction? My preference would remain debt reduction. But I doubt that the economic outlook is so charmed.
Just as the boom–the longest in U.S. history–was unprecedented, so may be its aftermath. The boom’s great propellant was a buying binge by consumers and businesses. Both spent beyond their means. They went deep into debt. Put another way, the private sector as a whole has been running an ever-widening “deficit,” says Wynne Godley of the Jerome Levy Economics Institute of Bard College. By his calculation, the deficit began in 1997 and reached a record 8 percent of disposable income in late 2000. Household debt hit 100 percent of personal disposable income, up from 82 percent in 1990.
What may loom is a protracted readjustment. “An increase in private debt relative to income can go on for a long time, but it cannot go on forever,” writes Godley. People and companies reduce their debt burdens by borrowing less and using some of their income to repay existing loans. The private-sector “deficit” would shrink. But this process of retrenchment would hurt consumer spending and business investment, which constitute about 85 percent of the economy.
It’s self-defeating for government to exert a further drag through growing budget surpluses. Of course, government could spend more. But politically, that isn’t likely–and spending increases take time to filter into the economy. A tax cut could be enacted quickly and enables people to keep more of what they’ve earned. Roughly speaking, the Bush tax cuts could raise disposable incomes of middle-income households (those between $35,000 and $75,000) by $1,000 to $2,500. This would make it easier for consumers to manage their debts and maintain spending. It’s also an illusion to think that lower interest rates (through Fed cuts and government-debt repayment) can instantly and singlehandedly stimulate recovery.
“The danger of a severe and prolonged recession is being seriously underestimated,” writes Godley. If you believe that–and I do–then a tax cut that made no sense six months ago makes eminent sense now.
