Tax Cuts or New Spending Could Be a Boon--but Should Be Temporary

Eight weeks ago in this space, I noted that our anemic economy was beginning to generate calls for tax cuts to help get it moving again. Since then, the economic news has gotten no better, and the calls for action have gotten louder. Monetary policy has been easing and the recent sharp cut in the discount rate has led to reductions in important market interest rates paid by businesses and households.

But recoveries from past recessions have generally been aided by added fiscal stimulus as well. In five of the past six recoveries, the structural budget deficit was made meaningfully larger. The recovery of 1980 was the exception. Then, both fiscal and monetary policy were tightened to fight inflation. They succeeded in aborting the recovery. In the other five cases, the structural budget deficit was increased by an average of 1.1% of GNP, which would be about $55 billion in today’s economy. By contrast, the structural deficit is now actually narrowing slightly, imposing a mild brake on the economy.

The case for short-run fiscal stimulus is not that the economy will never recover properly without it. My view is that if we added fiscal stimulus at this time, it is unlikely we would regret it a year from now and quite possibly we would help avoid a stagnant economy with persistent high unemployment. That makes it worth doing.

The big risk is not that we might overheat the economy in the short run but that, once the budget process is opened up, politics will enlarge long-run structural deficits--which ought to be smaller, not bigger. If that is where the budget discussion would lead, it might be better to let monetary policy try to promote recovery by itself.

To assure that the quest for short-run fiscal stimulus does not raise long-run deficits, only spending or tax changes that are explicitly temporary should be considered. To fit these objectives, the Budget Enforcement Act that is already in place could be modified by temporarily lifting the overall budget constraints for fiscal years 1992 and 1993 but not for subsequent years. Spending or tax changes that affect budgets beyond fiscal 1993 should be offset by other changes so that together they reduce--or at worst do not add to--long-run deficits.

A variety of tax or spending measures could help get the economy moving. Considerations of need and fairness, as well as avoiding adding to future deficits, should enter into the choice among them.

On the tax side, changes could be chosen to impact either short-run consumption or investment:

* If income tax breaks are used to boost consumption, a tax refund or credit that is paid out promptly would be better than a rate cut because it avoids the risk of becoming permanent and because its impact comes sooner. Theory says a temporary tax break will generate less spending than a permanent tax cut. But today many families would spend most or all of any added income. And if some part of a tax break went to reduce debt, that would not be a bad thing.

* Among incentives to boost investment rather than consumption, a temporary investment tax credit would have the strongest effect. A temporary credit not only leaves future deficits unchanged but has the added advantage of providing a bigger short-run impact than a permanent credit would. There would be even more bang for the buck if the credit applied only to investment above some fraction of previous investment. However, this would favor some firms over others. By contrast, with a temporary ITC, enhancing IRAs or reducing the capital gains tax would provide no near-term lift to investment or other spending. And despite the depression in non-residential construction, Congress should not be tempted to bring back passive loss deductions or any related subsidies to the construction industry. These would bring back the tax shelters that cost revenue and divert funds from where they are most productive.

On the expenditure side, a standard problem is that new projects take too long to have an impact. However, certain expenditure initiatives lend themselves to the current situation:

* Special one- or two-year grants to states and localities would help relieve the fiscal problems that are forcing many of them to raise taxes, lay off workers and curtail or compromise important services.

* Accelerating expenditures on already agreed-upon federal infrastructure projects would provide stimulus soon without creating new programs whose spending impact would be delayed and concentrated far into the future. Public construction programs have the added benefit at this time of using labor and capital resources that have been idled by the great slump that is underway in private construction.

The fact that defense spending can now be cut substantially will enter into budget discussions even in the near term. Congress should resist the temptation to pass permanent tax cuts for the stimulus they provide while looking to future defense cuts to offset their effects on the deficit. For a decade, rational discussion of budget priorities and national needs has been limited by lack of revenues. Perhaps future defense cuts will be large enough to permit funding high-priority programs, deficit reduction and tax cuts. But without evidence that it would permit all three, it would be a mistake to perpetuate the problems of a decade by making any permanent tax cuts now.