Cut Taxes to Guarantee the Recovery Will Continue

According to the National Bureau of Economic Research, which is the final word on such things, a recession began in July 1990 and ended in March 1991. Yet, during the 1992 presidential campaign -- long after the recession was officially over -- Bill Clinton convinced voters that the economy was still ailing and that President Bush was responsible. Clinton’s ability to successfully make that case was the single biggest factor in his victory.

The memory of those times guarantees that the U.S. economy is going to occupy much of President George W. Bush’s attention next year. He knows that the economic policies he sets in place in 2003 will largely determine his electoral success in 2004. The first President Bush, like his son, had extremely high approval ratings early in his term. Clinton won only by blaming his opponent day after day for mishandling the economy.

Perceptions tend to lag economic reality. It took almost two years after the 1990-91 recession had ended before most people believed that it was over, which presents Bush with a problem. In fact, the recession that began in March 2001 is probably behind us -- although the National Bureau of Economic Research has not said so yet. But according to a recent Los Angeles Times Poll, 61% of Americans believe we are still in recession. A big reason is that unemployment is still rising and may fall very slowly even after it has peaked. The lingering effects could be felt well into 2004.

This is why Bush has decided to put forward a big tax stimulus plan early next year, expected to be in the $300-billion range. It is also why he has made significant changes in his economic team, firing Treasury Secretary Paul H. O’Neill and his chief economic advisor, Lawrence B. Lindsey.

Bush feels he must get his ducks in a row next year, because by 2004 it will be too late. He wants to ensure that growth will be robust then, with low or at least falling unemployment. Given the unavoidable lag between changes in economic policy and their effect on growth and employment, any policy changes must occur as early in 2003 as possible to be effective in 2004.

Many economists believe that further stimulus is unnecessary. O’Neill apparently was one. Press reports suggest that he was fired for resisting the push for new stimulus, believing the economy was doing well enough on its own. After all, real gross domestic product was up 4% in the third quarter, well above its historical average. Adding new stimulus in a time of growth, Bush’s critics contend, could contribute to inflation and push the Federal Reserve to raise interest rates.

Without knowing the final details of Bush’s tax plans, I think he is right to see the balance of risks as weighing more toward the need for stimulus than lower deficits. The risk of doing nothing is significant, and the president’s stimulus package could be justified even if the economy was roaring. In the end, he has rightly concluded that the risk of a “double-dip” recession outweighs the risk of overstimulating the economy. So, what should be done?

In all likelihood, the president will set out to make some badly needed corrections to the way our tax system is structured.

The administration will probably propose some relief from the current double taxation of corporate profits. Taxes of up to 35% are paid once in the form of corporate income tax. The profits are taxed again -- at up to 39% -- after they are distributed to stockholders. In the end, the overall federal tax rate on corporate profits can be as high as 60%.

Economists have long criticized this system, saying that it encourages companies to borrow rather than issue equity and to retain earnings rather than pay out dividends. It also reduces investment by raising the cost of capital. Eliminating this kind of double taxation -- as most other countries have -- makes sense whether or not the country is in recession.

Reducing double taxation now, perhaps by allowing a partial dividend exclusion for investors, might also provide economic stimulus by boosting the stock market. With stock market wealth down by $8 trillion from its peak, people obviously are not as able or willing to spend. If reducing double taxation led to a jump in the stock market, as many economists think it would, then the result might be an increase in consumer confidence and spending, which would increase short-term growth. Economists call this the wealth effect.

Similarly, the likely Bush administration plan to increase depreciation allowances is another economic correction that makes sense regardless of how the economy is doing -- and it would also provide a short-term stimulus. Such allowances let businesses write off investments in facilities and equipment. Lagging business investment is a key reason for slow economic growth. By lowering taxes on investments in productivity-enhancing equipment, the government is encouraging something that will serve the economy both long- and short-term.

The principal argument against such tax incentives -- from both sides of the aisle -- is that they will further increase the budget deficit. The real problem with deficits is that they can cause interest rates to go up. But with interest rates at historic lows, the potential effects of a slightly larger deficit would be minimal.

In any case, the country’s most serious deficit issue is not the on-budget deficit, but rather the off-budget deficits in the Social Security and Medicare systems. Raising the long-run rate of growth by lowering taxes on savings and investment would do far more to help this problem than running a smaller deficit next year by resisting new tax cuts.

It may well be that the economy will recover nicely on its own even if there is no additional tax stimulus next year. But Bush cannot afford to take that chance. Even if he can’t get what he wants through Congress, he will want voters to know he tried. If it turns out there is a double-dip recession, the onus will be on those who opposed the stimulus, not on him.

Bush understands that, even with his party controlling the House and Senate, he faces a tough battle, especially in the Senate, where Democrats have powerful procedural weapons at their disposal to delay and amend presidential initiatives. At a minimum, they will extract a political price for giving the administration what it wants.

The president knows the stakes are high -- but worth the fight. He has carefully weighed domestic economic concerns against the great unknowns of a war with Iraq.

A successful war could ultimately have political and economic benefits, like lowering the price of oil by raising Iraqi oil output after a regime change. However, the short-term costs could be high, with temporarily higher oil prices and larger military outlays. Bush feels that his tax proposals -- with their likely results of raising stock prices, increasing business investment and spurring economic growth -- are needed to help offset any short-run disruptions that may result from war. I think he’s right.