Tax Cut: Swift Boost, Long-Term Debate

After all the fuss, what will be the effect of the long-promised, loudly debated tax cut that is about to become law?

The tax cut will give an immediate boost to consumer spending, but longer term, it is too small to have a significant effect on the economy.

However, as a policy choice--the Bush administration choosing to return surplus revenue to taxpayers in cash rather than in government programs--this tax cut marks the beginning of a decade-long debate over ways to run the U.S. economy.

The quick cash that will get to taxpayers through lower withholding rates retroactive to Jan. 1--perhaps including mailed-out rebates--should spur consumer spending.

The tax-cut cash “could be icing on the cake, coming when the economy is already accelerating,” thanks to Federal Reserve interest rate reductions, says Diane Swonk, the Chicago-based economist of Bank One.

Good news for consumers continues next year as tax rates start their gradual decline. For example, according to the agreement reached by congressional negotiators late Friday, the top marginal tax rate would decline from 39.6% to 35% by 2006.

The rate cuts will be geared to the top 40% of income earners--households earning $50,000 a year and above. Those income brackets account for 70% of all consumer purchases, notes economist Albert Wojnilower of Monitor Clipper Partners, a New York investment firm.

The benefits are not just for consumers. Lower tax rates for upper- and middle-income individuals will apply to most of the nearly 24 million small businesses in the United States, because taxes on almost all small companies are levied on their owners/shareholders rather than on a corporate entity.

The effect will be to lower a cost of capital for small business and, the Bush administration clearly hopes, to encourage investment and economic growth.

A main administration goal with the gradual tax cut is to boost economic growth in this decade to provide tax revenue and general wealth to finance major costs that will begin in the next decade.

Success is not a sure thing. This tax cut, to begin with, is relatively modest, notes Gordon Klein, a tax attorney who teaches at UCLA’s Anderson School. The 3% cut in rates is far less than the 20% cut in top rates, from 70% to 50%, that characterized the Reagan administration tax cuts of 1981-82.

Also, though it may sound odd, $1 trillion is not that much money spread over 10 years in an economy that now turns out $10 trillion each year in goods and services and within a decade will be producing at least $15 trillion a year.

In recent years, that enormous economy has grown rapidly and generated unprecedented tax revenue to the federal government, in individual income and capital gains taxes and in deductions for Social Security and Medicare.

Mounting government budget surpluses are the result--about $300 billion this year, projected to rise to $500 billion in the next five years.

But the surpluses are temporary because the increase in retired workers in coming decades will far outstrip growth in the numbers of active workers, the Congressional Budget Office notes. The bills for retirement income and health-care programs for the elderly will be gigantic.

How to pay those retirement bills is the real issue behind the fierce debates over the tax cuts.

The solution favored by the Democratic Party, which has regained control of the Senate, is to use today’s surpluses to pay off the $3.4-trillion national debt--the accumulation of Treasury bills and bonds that Americans and investors around the world have bought over the years.

The aim would be to clear the books in preparation for a new national debt to finance costs of the elderly in coming decades.

The strategy of the Republican Party--the Bush administration’s way--is to distribute part of the surpluses in tax cuts to boost economic growth and to consider changing the economic assumptions of the last 60 years with regard to benefits for the elderly.

Treasury Secretary Paul H. O’Neill has been outlining thoughts on entitlements of the elderly in interviews with the Financial Times of London.

Rather than government guarantees of old age pensions and health care, O’Neill said, “Able-bodied adults should save enough on a regular basis so that they can provide for their own retirement and health and medical needs.”

The differences between the parties are matters of degree and of philosophy. Democrats in general would expand government benefits. The party’s program to finance prescription drugs for the elderly involves more government support than the Republicans’ prescription drug plan.

The Republicans typically rely on private markets to accommodate social needs. A big reason for the Republican emphasis on tax cuts is the party’s philosophy that limits should be maintained on governmental programs.

Common to both parties is a recognition that the funds needed in future decades, as advances in medicine enable people to live longer, will be enormous. How to pay those bills will be the big issue of congressional elections in 2002 and all other federal elections this decade.

Meanwhile, the economy has slowed. Growth in the first quarter was only one-fourth that of a year ago as business investment fell flat and profits declined.

The surpluses are a drag on the economy, economists explain. Tax cuts or government spending is needed to get surplus tax revenue back into circulation in the economy.

An argument for using tax cuts to distribute the surplus, says economist Edward Yardeni of Deutsche Bank Alex. Brown, a New York investment firm, is that taxes are at a relatively high level. As a percentage of the economy’s gross domestic product, income taxes are at their highest level since 1944--when the government was financing World War II.

So taxes will be reduced, boosting consumer spending. But whether that revives the slow economy remains a question.

Lagging profits and business investment are causing today’s slowdown, economists note, not a pause in consumer spending. “We’re at a peak in a cycle of business investment and must work off what [excess production capacity] we’ve put in place before profits and investment revive,” says Charles Clough, head of Clough Capital, a Boston investment firm.

To be sure, tax cuts could prove an elixir. A burst of consumer spending, which accounts for 60% of the vast economy, could revive profits and prompt new investment.

The economy’s performance will answer the question of tax cuts’ effectiveness fairly quickly. Other questions of an aging society and economic policy will be with us for the decade and beyond.

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James Flanigan can be reached at jim.flanigan@latimes.com.

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Breaking Point on Taxes

Income taxes as a percentage of the total U.S. economy, as measured by gross domestic product, have risen above 9% in recent years and hit a 40-year high last year. The last time taxes rose to such a high percentage of GDP, 1981-’82, a tax cut followed. And another tax cut is in the works.

Income taxes as a percentage of GDP

2000: 10.2%

Source: Congressional Budget Office