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the years, supply-siders have understood that there is no substitute
for the real thing. Near-term adjustments in interest rates or tax
structures may in fact give the economy a kick in the growth direction.
But unless there is real, long-term change, these "substitutions"
only steal from the future.
We can see
this clearly with interest rates. When interest rates are declining
and are expected to continue to decline, people have an incentive
to delay purchases of consumer durables and to delay home refinancing.
However, once interest rates hit their bottom and are expected to
increase, the floodgates open. Supply-siders argue that during periods
of declining interest rates the economy should slow. Witness the
current slowdown. And when rates have bottomed and are expected
to rise, the economy is expected to pick up.
The methodology
easily extends to other examples. The "Big Three" automakers
are now offering zero-interest-rate promotions. It is reasonable
to assume that carmakers are not going to offer negative interest
rates. Hence, this is as low as it is going to get for car financing.
Not surprisingly, consumers have jumped at the offer and cars are
selling like hotcakes. The temporary "price reduction"
has worked and inventory is being worked down, solving the carmakers'
previous production mistakes.
However, if
one looks a little more closely, all that actually is happening
is that the automakers are stealing from future sales. In the near-term,
shortly after the promotion ends, car sales are going to slow, perhaps
significantly. That means future car production will unambiguously
slow. This trade-off, or substitution, may be desirable now, but
it only eats away at future production rates.
Substitution
effects can also be witnessed on the tax front. The 1986 Tax Reform
Act raised the capital-gains tax rate to 28% from 20%, and the prospect
of higher tax rates on existing investments led to a flood of transactions
in which investors realized huge amounts of capital gains. The increase
in realization led to a surge in capital gains tax-revenue collections
that flooded the coffers of both the federal and state government.
Interestingly,
the geniuses at the State Tax Board in California failed to realize
that the surge in revenues was a one-time event. Instead they projected
higher tax revenues into the future and ramped up spending to match
the projected higher revenues. We know what happened afterwards:
rather than reduce the spending in recognition of the temporary
nature of the revenue surge, Gov. Pete Wilson raised taxes and pushed
California into a terrible recession. This incident illustrates
how supply-side effects may lead to policy mistakes for those who
ignore them. However, not all was bad. The incident demonstrated
that changes in the incentive structure can have powerful short-term
effects on the economy.
Another example
of a temporary effect was produced in the early 1980s during the
first Reagan tax-rate cut. Recall that the rate cuts were phased
in and the top marginal rate on earned income of 50% was reduced
gradually to 28%. Look at the after-tax rate of returns during the
transitions. The first year the taxpayer in the highest tax bracket
would keep $0.50 out of every dollar earned. After the tax cuts
were fully implemented the taxpayer would keep $0.72.
In short, with
the same pre-tax cash flow, any taxpayer that was able to shift
income from the early years to the latter years would increase after-tax
income by 44%. During that time people devised a variety of ways
to shift income. One easy way was to overpay state and local taxes.
The taxes would be written off against federal taxes at the higher
rate. The refund would be taxed at the lower federal taxes the next
year. Other people simply delayed income recognition by absence
of work. During that time the U.S. experienced a recession and the
economy did not show any signs of life until the bulk of the tax-rate
cuts were in place.
These were
the short-term effects of the rate cuts. But there have been some
long-term effects, too. Lower tax rates increased incentives to
work, produce, and save. It is not a coincidence that the U.S. resurgence
coincided with the reduction in tax rates, the reduction in regulations,
and the reduction in the inflation rate. The policy changes led
to a permanent shift in the structure of incentives in the U.S.
economy.
Bush
in Deed
The election of George W. Bush offered the promise of a new round
of incentive-increasing measures that would lead to a permanent
reduction in the tax rates. However, there were some doubts as to
whether the new administration was a true believer in the supply-sider
credo. Bush talked a good game and still does. However, one has
to judge deeds, not words.
The Bush proposal
promised to lower tax rates, eliminate the death tax, and to reform
Social Security. In some respects the president is keeping his word.
However, one is correct to be somewhat disappointed by the phase-in
and temporary nature of the program. While these are due to static
revenue budget constraints and may reflect a political reality,
they also reflect a lack of understanding or belief in short-term
substitution effects.
One way to
justify the phase-in of tax rate cuts is to assume that short-run
substitution effects are not that important and only the long-run
incentives matter. However, that does not square with the 1986-87
capital-gains experience or the automakers recent experience. Substitution
effects seem to be important. If one believes that the long-run
effects are what matter, then why make the death-tax reduction a
temporary one?
Perhaps the
justification for this Bush initiative is that political pressures
will not let Congress reinstate a 55% death tax from a zero tax
rate. Under that scenario, after 11 years, we would have a permanently
lower personal income-tax rate and no death tax. If this is the
case, we would enjoy all the long-run benefits, even if we feel
that the implementation costs are unnecessarily high.
Armed with
this analysis we can now focus on the current economic situation.
Economists and the administration have proposed a number of temporary
measures to aid the economy. In the analysis of these we need to
focus on two effects. The first is whether the policy changes would
have a short-term effect and, second, whether that effect is permanent.
That is, whether it permanently improves the incentive structure
of the economy.
One of the
president's proposals is to accelerate the implementation of the
personal income-tax rate reductions. In terms of incentive effects,
this measure is a winner. A reduction in the top personal income
tax rate to say 35% from 39.6% would increase after-tax take home
pay to $0.65 on the dollar from just over $0.60. That's a 7.6% increase
in the after-tax rate of return. So, Americans would have a 7.6%
increase in their incentive to work and produce beginning January
1, 2002. In the meantime, they would have a 7.6% incentive to delay
income recognition. Given the short period between now and the end
of the year, the annualized rate is phenomenal and growing. One
can expect people to slow production until the beginning of next
year.
The proposed
30% increased depreciation is a good deal, too. Expensing is the
optimal and desirable policy. Thus, anything that moves us closer
to the expensing ideal is a move in the right direction.
Here's how
to look at the issue: Under current law, companies are allowed to
depreciate 100% of their capital expenditures. Under a 35% corporate
income-tax rate, a company would be able to shield $35 worth of
profits for every $100 in revenue. However, under current law, the
depreciation must take place over several years. Hence, the net
present value of the tax shield will be less than $35. Thus, advancing
the depreciation schedule gets us closer to the $35 shield.
Consider the
case of a 30% advancement in the depreciation schedule. On a $100
investment, a company will now be able to shield an additional $10.50
this year. However, it will lose $10.50 worth of tax shield in future
years. At a zero interest rate, companies would be indifferent.
However, with positive interest rates they are clearly better off
by the proposal. How much better depends on the level of interest
rates and the length of the depreciation schedule. We know that
the higher the interest rate and the longer the depreciation schedule,
the greater the benefits from the additional 35% depreciation. An
additional point to make is that in order for the tax shield to
be of any value, a company has to have positive earnings to write
the depreciation off.
The Bush administration
proposal could be a good one if written and implemented correctly.
However, the proposal seems to suffer from a bland form of supply-side
economics. It is trying to be too cute.
By enacting
a temporary provision it forces people to increase their expenditures
in the short-term. This, they would argue, helps get us out of the
recession. But there are a few problems with this logic. One is
that if the measure is just altering the timing of economic activity,
it will have no permanent effect on the economy — all we are
doing is stealing from the future.
Look
Long
The only way to justify these measures would be if somehow the famous
Keynesian multiplier existed and (for once) it actually worked.
The argument would be that the increased purchases of capital equipment
would lead to a multiplier effect that would lift us out of the
recession. This seems consistent with some of the comments made
by the president's economic advisors as well as the president himself
— particularly Bush's line that we are all supply-siders and
Keynesians now. But if there is no multiplier the only way that
we can have a long-term benefit is by lowering the effective cost
of capital permanently by making the higher accelerated depreciation
permanent.
Another example
of a temporary solution to stimulate the economy is the proposed
sales-tax holiday. It is a fine measure if the objective is to raise
tax revenues in the short-run. It may also be a fine measure if
one believed in the multiplier effect. However, if one remains true
to his supply-side roots, the temporary measure would only steal
from the future without permanently increasing incentives
to work, save, and produce. That's simply not what supply-side economics
is all about.
Short-term
incentive effects to stimulate the economy are fine as long as they
dovetail with permanent incentive effects. The president should
apply the arguments used to advance the personal income-tax rate
cuts, to accelerate the depreciation schedule permanently, and to
eliminate the death tax.
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