The Economic Case Against Bush's Tax Cut

NEW YORK: Washington politicians are worried over signs that America’s great structural boom of the past five years is over: a poorer outlook for profits, increased corporate debts, and a related slowing of business investment in fixed capital, new customers and new employees. If the boom is over, the structural unemployment rate – alias the ‘natural rate,’ or Nairu – will rise to a more normal 4.5 to 5%. Alan Greenspan, chairman of America’s Federal Reserve, can help by avoiding tight money but he cannot undo this structural shift.

What is to be done? Talk in Washington portends a lurch away from the “sound finance” of the 1990s – the increased tax rates and tighter grip on spending that replaced budget deficits with budget surpluses. Republicans propose a massive tax cut while Democrats favor a package of greater spending and a lesser tax cut, but which has the same budgetary cost as the Bush plan. Either plan would blow a huge hole in this year’s surplus. Future surpluses would disappear by the decade’s end, if not sooner.

Several economists object to either course. We agree there may be some welcome effects in both the proposed Republican and Democratic tax cuts. Research – of mine and of others – confirms that changes in personal income tax rates (the largest part of President Bush’s plan) do have an impact on structural unemployment, not just net paychecks. It’s common sense that an income tax cut, in raising after-tax pay rates, boosts employees’ and managers’ incentives, reducing costs and raising profitability – in large part because the returns on workers’ wealth mostly escapes income tax. What is at issue is the justification for the drug of income tax cuts, with its worsening counter-effects and serious side effects.

The oldest consideration weighing against a tax cut goes back to 1950s neo-Keynesians, who viewed tax cutting as anti-growth. That doubt remains valid. An income tax cut, in stimulating consumer demand, diverts resources from making non-tradable capital goods – plants and offices – to non-tradable consumer goods. In forcing US interest rates higher, such a tax cut would crowd out many other types of domestic investment, which can only serve to slow development of the Internet economy and slow productivity.