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November 27, 2002, 8:30 a.m. Stimulus Strategies Some tax-cut proposals are better than others.

he race is on to develop a tax-cut package that will add some measure of fiscal stimulus to the economy. After the Republican success in the mid-term elections, the stimulus is likely to take the form of changes in tax law rather than increased government spending, although we shouldn't rule out some increases in spending for political reasons.

The Wall Street Journal recently enumerated various tax strategies that were being discussed by the president's advisors as the basis for stimulating the economy in 2003 and beyond. Since the Senate is not filibuster proof, it is likely that the Republicans will attempt to mollify the Democrats by coming up with a package of tax cuts that will include generous accommodations for middle-class voters. Given the diverse interests of various political factions in the development of a viable tax package, it is worth evaluating the implications of various proposals to estimate their real potential for increasing economic output.

Let's take a look:

Acceleration of the 2001 tax cut. While most tax-rate cuts encourage output by providing incentives to work harder, the timing of such tax cuts can have an important temporary effect on economic activity. For example, a car dealer knows better than to announce a car sale for next week — he might as well tell his salesman to take this week off. In other words, future tax cuts induce the postponement of economic activity to future periods when tax rates are lower. For all it's worth, the phase-in of the current tax cuts tends to postpone economic activity, not encourage it. Therefore the acceleration of the tax cuts makes a lot of sense — as long as there is no large time gap between now and when the larger tax cuts take effect, as that might cause a temporary drop-off in economic activity.

Unfortunately, there is still discussion about how much the accelerated cuts would "cost" the government. Of course, these so called cost estimates are made in a framework of static analysis as if the successful impact of the tax cuts on increased economic activity wouldn't produce any increased tax revenues. This failed argument was made against the Reagan tax cuts back in the 1980s. As Bruce Bartlett has documented, the Reagan tax cuts increased tax collections, especially from the rich. The reason is clear: increased economic activity based on the incentive of lower tax rates did the job and put America back on a growth path. Let's avoid going back to the flawed theories that tax-rate cuts "cost" the government.

Targeted tax cuts. In the aftermath of the technology meltdown that led to the first recession of the 21st century, capitalists are clamoring for targeted tax cuts that encourage purchases of new equipment. The problem with targeted tax cuts is that the value of the outcome is uncertain.

For example, the story is told that the government of an eastern European country decided to offer an incentive to workers in a nail plant. The workers would get a bonus depending on the tonnage of nails they produced. While the government found itself paying a large bonus to the workers, indicating that output had risen, the problem was that the ten-pound nails produced by the factory were useless. Similarly, we shouldn't encourage companies to make investment decisions based on a manipulation in the tax code. If anything, a reduction in corporate tax rates across the board would provide the best use of manpower and machine power. Why in the world would you want to lower taxes to encourage investments in equipment when productivity is already zooming but unemployment is climbing?

Another area that deserves a second look is retirement savings. While techniques to encourage people to save for retirement stand on their own merits, it is unlikely that tax deductions will do much to stimulate the economy. By increasing contributions to savings, individuals are likely to save more and spend less, adding to the slowdown and not contributing to economic growth. Similarly, some have questioned the stimulative impact of a reduction in the capital-gains tax from, let's say, 20% to 10%. They argue that such reductions encourage the sale of securities, thus temporarily depressing financial markets and not contributing to higher stock prices.

The bottom line for adopting a viable targeted tax strategy is the ultimate effect that each targeted tax cut will have on the economy — and not which constituencies will be made happy.

Tax simplification. A major problem with the tax code is complexity. The government should design tax laws to efficiently collect taxes to meet spending needs. Instead, the tax code has evolved into a huge special interest tug of war to see who can craft the biggest benefits through various exceptions to the tax code. Corporations are the top offenders, inasmuch as they can spend the most money figuring out ways to avoid paying taxes. However, wealthy individuals also have their fair share of sophisticated lawyers and accountants who craft some unusual gimmicks to get around the current tax code.

The economy would be much better off if the corporate income tax was totally eliminated. While it would appear "unfair" to most observers, such a change in the tax law would benefit both corporations and consumers. In a competitive environment, most companies would be forced to pass those tax savings on to consumers through lower prices. Corporate bottom lines would benefit from the ability of management to concentrate on their businesses, and not schemes to avoid paying taxes. The government would also be able to reduce the cost of enforcement.

Proposals abound for tax simplification — and they're not all good. One proposal is to substitute a value-added tax for part of the income tax. But such a change shifts the tax burden from income to consumption. Older folks (who have done most of their consuming) would benefit at the expense of younger folks (who are trying to raise families and make large outlays for clothes, furniture, transportation, and housing). But then again, younger folks get tax breaks for their children. The complexities go on and on.

A less controversial strategy is the implementation of a flat-rate tax that would apply to both corporations and individuals. There would be few if any deductions and the flat rate would be quite low; some analysts calculate that a 11% to 15% rate would produce the same revenue as the current tax code.

President Bush and the Congress should act quickly to implement a program to stimulate economic activity. A Republican-controlled government will lean towards tax reform rather than outright spending increases as the tool to accelerate economic growth. In the process of deciding on the right tax package, all participants should study the ultimate effects of any tax program and choose the one that has the best chance of getting the economy back on a strong growth track.

ERRATA
In my recent piece entitled "Bye, Bye, Bear," I erroneously referred to Richard Bernstein, a strategist with Merrill Lynch, as one individual who lost his job because he was bullish. The person who lost his job was Bruce Steinberg, one of the firm's economists.

— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.