Politics & Policy

Keep The Good Times Rolling

Policymakers who don't act to extend the 2003 tax cuts do so at their own peril.

National polls almost always find that the economy is the top issue for voters, though when voters feel secure about the economy they have the luxury of focusing on other issues. When the economy is going gangbusters, it also recedes in importance where policymakers are concerned.

Well, the economy is going gangbusters. The increase in the gross domestic product for the third quarter has just been revised upward to 4.3 percent, making for ten straight quarters of robust economic growth.

With the good times rolling, policymakers have little incentive to push additional pro-growth proposals, given the political costs necessary to make these into law. But this is a dangerously short-sighted view.

The current prosperity is not an accident of the business cycle; it is the result of a policy mix deliberately crafted to encourage investment and entrepreneurial risk-taking. Yet nearly all of the policies that make up that mix will, by design, be undone in the next few years. If this is allowed to happen, a recession could follow — one that will instantly make the economy the number-one issue for almost 100 percent of voters.

Look at the numbers. Overall GDP growth was a robust 4.2 percent in real terms in 2004 and more than 3.7 percent for the first three quarters of 2005 — significantly faster growth rates than the post-World War II average of just over 3 percent. Unemployment, even after three major hurricanes, remains at a historically low rate of 5.1 percent. Payroll employment, which itself undercounts jobs by ignoring the burgeoning ranks of the self-employed, continues to set new records every month.

Consumer spending never flagged much during the recession. It grew by a respectable 2.5 percent even in the recession year of 2001. The story of that recession was a collapse in business investment, which declined in real terms for two consecutive years, shrinking 7.9 percent in 2001 and another 2.4 percent in 2002. The 2003 tax-rate cuts supercharged business investment, which climbed by 4.4 percent in 2003 and an outsized 13.2 percent in 2004.

The 2003 tax bill was a huge supply-side success story. The bill’s provisions, especially the capital-gains rate cut, the dividend rate cut, and the small business expensing provisions, boosted the after-tax returns on capital and encouraged a sharp turnaround in business investment.

With the budget deficit standing at a paltry 2.6 percent of GDP and the economy humming along, it should be unthinkable that policymakers would enact a series of massive tax hikes that could derail the good times. The natural instinct among policymakers — who are risk-adverse creatures in general — is to leave well-enough alone when the public seems to be happy. Unfortunately, congressional inaction now will obliterate the successful policies that have supercharged this economy.

Unless Congress extends the 2003 tax cuts, the following will occur: Small businesses will be hit with a tax increase on capital expenditures, raising their cost of capital and hampering innovation and entrepreneurship; the tax rate on capital gains will increase 33 percent, destroying trillions of dollars of shareholder wealth and slamming the brakes on economic growth; the tax rate on dividends will increase by a staggering 133 percent, making companies less accountable to investors and creating strong incentives for companies to inefficiently hoard cash; and individual income-tax rates will increase, the top rate by over 13 percent, creating a disincentive to work and produce.

Inaction by Congress, in other words, will result in a massive tax hike, one that will be particularly onerous for seniors (many of whom are likely voters) who rely on dividend income.

If all this is not bad enough, even the uncertainty created by the chance that the tax cuts won’t be extended could be enough to undermine investor confidence, reverse the stock market recovery, and derail economic growth. Predictability is the mother of business confidence. If there is an expectation that these tax hikes will occur, the cost of capital could increase enough to send the economy into a tailspin.

The White House and Congress need to recognize that action is required if the good economic times are to keep on rolling. Lawmakers must act to prevent scheduled tax hikes — preferably by permanently eliminating them but at least by pushing them off as far into the horizon as possible under Senate procedures.

When the economy falls far enough, it quickly becomes the top issue for all Americans. Politicians who ignore this reality do so at their own peril.

Phil Kerpen is policy director and Peter Roff is vice president for the Free Enterprise Fund .


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