Responding to the stock-market crackup and the deepening economic slump, lawmakers in Washington are now coming around to the view that deeper tax cuts in this year — 2001 — will be necessary to halt the economy’s slide and open the door to economic recovery. The good news is that the political class at least realizes the need for more-immediate tax relief. The bad news, however, is that a $60 billion rebate check to all taxpayers is the wrong economic medicine.
Far, far better would be a front-loaded acceleration of the marginal tax-rate reduction planned to begin next year. In other words, across-the-board tax-rate relief made retroactive to January 1, 2001 would have the maximum impact on individual work effort and investment. IRS withholding rates could be adjusted downward as soon as a tax bill is signed into law. Therefore, people would benefit by midyear with increased cash flows and lower marginal rates that would strengthen economic returns.
The cash-rebate plan is primarily aimed at temporarily bolstering consumer spending. Ironically, personal-consumption expenditures are actually the strongest part of today’s sagging economy. For example, in last year’s fourth quarter, inflation-adjusted consumer spending increased at a 4.75% annual rate. In the current quarter, for which GDP will be reported in late April, real consumer spending could rise by 3.25%.
It is investment spending, however, in the form of diminished stock-market purchases and business-equipment expenditures, that is falling badly and pulling the economy down. In last year’s fourth quarter, domestic investment spending declined at a 3.25% annual rate, and business investment in the first quarter is also likely to fall.
More, the economy is suffering from a massive deflation of wealth capital. By some accounts, stock-market losses have erased nearly $5 trillion of wealth. And the Federal Reserve reports that family wealth dropped $2 trillion last year — the first decline in at least 20 years.
So it is capital investment, not consumption, that is today’s number-one economic problem. The best way to replenish lost capital is to increase after-tax rewards and reduce after-tax hurdle rates on capital investment. Tax-rate reduction for upper-bracket income earners is really a tax cut on capital, whereas rate reduction on lower income earners is more a tax cut on consumption (though greater work-effort incentives do kick in at the lower end).
Also, roughly one-fifth of upper-bracket filers are small-business firms, Subchapter S companies, and limited-liability partnerships. So, in effect, dropping the top marginal tax rate is not only a tax cut on capital, but a tax cut on business as well.
And let’s not forget the capital-gains tax. If ever there was a time to reduce tax barriers on capital — be it equity capital in the stock market, or business capital more generally — now is the time to increase rewards on these forms of investment in order to revive badly sagging animal spirits.
The investor class is in shock at its massive wealth loss over the past year. Capital-gains relief and marginal rate reductions on personal income would be much needed antidotes. Keynesian economists always look to consumption stimulus. But in reality, it is investment and production gains that create jobs — and jobs create incomes for consumer spending. Paraphrasing the classical French economist Jean Baptiste Say, we invest and produce in order to consume. Jimmy Carter-type tax rebates do nothing to promote investment and production. But supply-side tax-rate reductions can. If, on the other hand, investment and production incentives are not strengthened, then declining jobs, income, and consumer spending will pull the economy down into a nasty second-half recession.
So, President Bush’s entire tax-rate relief plan should be front-loaded right now. Supply-side tax cuts will end the stock market and economic crisis almost as soon as the ink is dry on a new 2001 tax-reform plan. The combination of growth-inducing tax-rate cuts and expanded Federal Reserve liquidity is the right policy mix. A 1970′s-style rebate, however, is a waste of resources that could actually make the patient worse.