But to Give the U.S. Economy a Boost, a Temporary Tax Cut Could Help

The anemic economic recovery has led to calls for tax cuts from members of both parties in Washington. But President Bush has not joined the movement, in part because he has used last year’s budget agreement to rule out any fiscal initiatives, and in part because he has been getting mixed advice about both the economic and political desirability of tax cuts now.

The Christmas shopping season will provide more information about the strength of the expansion, and further signs of a weak economy would strengthen the economic case for tax cuts. If the President’s popularity continues to sag, tax cuts will look attractive for political reasons as well. Should the President want to go for tax cuts, Congress will not resist, and between them they will have no trouble getting around the budget agreement.

But would tax cuts be a good idea? The majority of economists oppose them as a way to strengthen the recovery, but for a mixture of reasons rather than a compelling one. A few believe that fiscal actions, whether on taxes or expenditures, have no effect on the pace of economic activity, and so would be pointless as anti-recession measures.

My reading of the evidence points the other way. Some believe that, although tax cuts would add to consumer spending, they would also raise long-term interest rates, thus providing little or no net lift to the economy. To the extent that tax cuts quicken the expansion, interest rates would be higher. After all, bonds rates would be lowest if a depression were expected. But unless tax cuts were perceived as recklessly enlarging future deficits, long-term rates should not rise so much that they offset the tax stimulus.

Finally, many economists oppose tax cuts now because they would enlarge the structural budget deficit in the future, when the economy is near full employment. They see the excessive structural deficits of the past 10 years as one important cause of the weak investment and poor productivity of that period, and see a reduction of the structural deficit as the top priority for fiscal policy.

It is important to reduce the long-run deficit. But with the recovery as weak as it has been in recent months, the near term deserves some attention as well. Federal Reserve officials clearly believe that the expansion is too weak; they just recently cut the discount rate from 5% to 4 1/2%. But monetary ease will work best if it is in harness with fiscal policy.

Most recoveries of the postwar period were aided by a combination of fiscal and monetary easing. Yet right now, fiscal policy is at best neutral and may even be moving toward restraint as defense spending starts to fall. It is extremely doubtful that a tax break would overstimulate the economy, and it might help head off a drop into a renewed and deeper recession.

As for the concern with deficits in the longer run, if future defense spending could be cut far enough, some permanent tax reductions might be consistent with declining deficits and other budget priorities. But there is no need to count on that or to take such a permanent step in haste.

The best course for now would be a fiscal package that provides a lift to demand in the short run but phases out as the economy comes out of its slump and approaches full employment. In principle, such a near-term lift could come from aid to temporarily hard-pressed states that are being forced to raise taxes and lay off workers, or from an acceleration of already agreed-upon federal spending projects. But realistically, tax breaks are the only form of stimulus likely to be on the political agenda. They could be made temporary or could take the form of a one-time rebate.

It is ironic that the proposals that would be most likely to help the recovery are being put forth by Democrats, whose chances of unseating President Bush a year from now would be greatly enhanced by a weak economy. Texas Sen. Lloyd Bentsen’s proposal to provide a tax credit of $300 per child exemplifies the Democratic approach. Most of that money would go to families with tight budgets who could be expected to spend it promptly.

By contrast, everything reminds the President of the capital gains tax. Cutting it, as proposed by other leading Republicans, would probably be the centerpiece of any tax proposal put forward by the White House, together with the reintroduction of the old IRA tax preferences that were eliminated in the 1986 tax reform.

Whatever else one believes about cutting the capital gains tax, nobody expects it to stimulate spending in the short run. And advocates of IRAs favor them because they believe that they would restrain spending in favor of saving. By no stretch is either an anti-recession measure.

The most valid reason for opposing tax stimulus at this time is the fear that, once started, tax cutting would get out of hand. A compromise that pleases everyone in the coming election year would give the White House the capital gains breaks it wants, the Democrats the middle-income tax relief they believe is overdue and everyone the IRAs that constituents remember fondly. The additions to the deficit would be large and would grow with time rather than diminish as the economy expanded out of recession.

The mistrust of the political process may be good reason to hope that the tax-cut movement never gets rolling. But it should not be confused with bad economic arguments. Temporary, well-aimed tax relief would be a timely supplement to lower interest rates in today’s economy. If that option is not available, it is a mark against the political leadership in Washington.