How to Restart the Engine
With the immediate shock of the Sept. 11 attacks subsiding, restarting the stalled U.S. economy is a critical priority. Unfortunately, the stimulus package under consideration on Capitol Hill is simplistic, politically timid and incapable of fueling a sustained recovery. What’s needed instead is an approach that builds consumer and investor confidence in the economy’s long-term prospects. Toward that end, income and payroll taxes should be slashed by 10% to provide an immediate $170 billion boost to the economy. At the same time, the government’s fiscal flexibility should be enhanced by reducing Social Security, Medicare and other entitlement outlays to wealthier, self-sufficient Americans.
The 10-year, $1.5-trillion tax cut that Congress passed earlier this year will do virtually nothing to reverse the current economic slump, because most of its benefits will be realized several years from now. Proposed measures like big-company rebates, airline bailouts or depreciation schemes to boost computer purchases risk prolonging the recession. They also dangerously skew the economy in favor of politically powerful, but economically less vital sectors.
Temporarily increasing government spending for infrastructure and defense will have an especially illusory impact. Much of this spending will pay for damages caused by the terrorist attacks or will go toward fixing chronic security lapses. As such, it compensates for economic losses America has already incurred, rather than generate new economic benefits.
More important, short-term government spending or targeted relief can help trigger a sustained recovery only if investors’ long-term fears are also allayed. Few consumers will buy a house during a recession simply because they receive a few extra dollars from the government. Many would consider a big-ticket purchase, however, if lenders are simultaneously persuaded to drop long-term interest rates and consumers’ future employment and income prospects markedly brighten.
The nation’s current situation is, in many ways, strikingly similar to the early 1990s. In 1987, newly appointed Federal Reserve Chairman Alan Greenspan had unaccountably raised interest rates, which contributed to a stock-market crash in October. Fearing an economy-wide collapse, he quickly reversed course. The Fed cut its discount rate, the interest it charges key banks and depository institutions, from 7% in late 1990 to 3% in 1992.
The economy did not respond well to the Fed’s monetary stimulus. Rising budget deficits generated inflation fears and consumed much of the nation’s capital. The 1980s’ savings and loan fiasco was still unraveling. Iraq’s incursion into Kuwait in 1990 and the ensuing Persian Gulf War shook investor confidence.
Reflecting these uncertainties, long-term capital costs stayed stubbornly high despite the Fed’s rate cuts. By early 1992, the interest rate of the nation’s benchmark 30-year Treasury bond, a key measure of long-term lending confidence, was more than 21/2 times higher than the Fed’s discount rate, the largest gap in postwar U.S. history.
Greenspan and then-Treasury Secretary Robert E. Rubin realized that something more than monetary stimulus was required to push the economy forward. They decided to change the market’s perception that the federal deficit was out of control. If most federal spending, save for Social Security and Medicare, could be frozen, defense outlays cut and taxes raised, they contended, America’s skittish bond markets would be reassured. Accordingly, long-term lending rates would fall, and the economy would get a vigorous jolt from access to less expensive capital.
Their gambit succeeded. From 1992-97, the federal budget increased by just 3% a year, compared with nearly 7% in each of the previous five years. Long-term Treasury bond rates correspondingly fell from more than 7% in January 1993 to less than 6% by November of that year. By the end of 1997, well before the Asian financial crisis and dot-com mania helped feed the economy’s bubble phase, the growth rate of the S&P; 500 index had tripled, real domestic output rose by 50% and job growth increased from less than zero to more than 3% a year.
Today’s economy also suffers declining confidence in the economy’s long-term prospects. Job losses have pushed employment growth into negative territory. The spectacular downfall of Information Age investments and the sudden realization that endless prosperity is not guaranteed have deeply undercut market confidence. Manufacturing retrenchment has peaked at a postwar high. Novel threats like anthrax and a potentially long war against terrorism are generating considerable unease. And, as in the early 1990s, the Fed’s relentless drive to cut short-term rates has not produced the desired recovery.
Cutting income and payroll taxes, which principally fund Social Security and Medicare, by 10% would do for the economy what the budget deal did in 1993: It would dramatically improve the way investors and consumers view their long-term prospects. Income-tax cuts would immediately put new money in the hands of consumers and investors by reducing withholding burdens. Payroll tax cuts, in particular, would assure that lower-income taxpayers and the businesses that employ them (companies pay half of such levies) would receive significant relief. And by providing a more substantial stimulus to the economy than is currently proposed, Washington will enhance the chances of a quick recovery.
Cutting income and payroll taxes, rather than pursuing a hodgepodge of special-interest rebate schemes would also demonstrate a sustained commitment to reward work and investment throughout the economy. Earnings and consumption would increase for all Americans; investments in every sector, not just those with pull on Capitol Hill, would rise. Few, if any, policies can more progressively and effectively revive economic confidence.
These results, however, cannot be achieved without sacrifice. The nation must be able to continue to pay for its military, civil defense and other government functions. The best way to give the government the budgetary flexibility it needs and avoid fiscal insolvency is to restrain spiraling entitlement spending and stringently means-test Medicare, Social Security and similar programs.
According to Robert Bixby of the Concord Coalition, a group that advocates responsible fiscal policy, even a relatively relaxed means-test that ignored a beneficiary’s non-income assets--stocks or real estate--would save more than $60 billion a year in Medicare and Social Security costs alone. If non-monetary assets of the wealthiest are also considered in the allocation of all federal entitlement spending, as they should be, the total annual budget savings would likely offset most of the income and payroll tax cuts.
It is, to be sure, asking a great deal of America’s wealthiest to forego federal entitlements, but there are several reasons why they should. Tax reductions that stimulate an economic recovery, for one thing, will almost certainly generate more net benefits for such individuals. Helping assure that America has the economic wherewithal to fully respond to terrorism and protect its citizens is of obvious importance to everyone. And a modest, but essential sacrifice by wealthier Americans will directly involve all the nation’s generations and classes in the pursuit of a national priority.
Cutting income and payroll taxes while simultaneously reforming federal entitlement programs would meet our economic and security challenges in a fair and economically responsible manner. Congressional leaders were roundly criticized last week after unceremoniously fleeing the Capitol in the wake of an anthrax scare. As they belatedly return to craft a stimulus package, they should seize the opportunity to show the world that, in response to the twin threats of recession and terrorism, America truly means business.
