Here are 400 billion reasons President Bush's 2001and 2003 tax cuts may not see the next decade of the 21st century. The five-year federal budget proposed by Senate Democrats last week lets the reductions stay in place after their current 2010 expiration dateif backers can come up with $400 billion to pay for them in 2011 and 2012. Extending them to 2017 would "cost" $1.8 trillion. (This sort of static analysis oddly assumes that taxeswhether higher or lowerhave no economic impact.) Now given that the current Congress is having trouble coming up with $40 billion-$50 billion for a temporary fix to the alternative minimum tax, finding a spare $200 billion a year seems like a tall order indeed. "After 2008, the default budget position is going to be higher taxes," concluded Tom Gallagher, a veteran political analyst at International Strategy & Investment Group, in a recent chat.
Most Washington watchers say that the Bush capital gains, dividend, and marginal rate tax cuts would be left to die with only the social policy tax cutssuch as increased child tax creditstanding any chance of surviving. Democrats could easily argue that higher taxes are needed to pay for healthcare reform, Social Security reform, climate change research, public works investment, or reducing income inequality. The major GOP presidential candidates say they intend to preserve the cuts if elected, but if Democrats also control the next Congress, they will have a tough time doing so. Yet here's the thing: If Bush's primary domestic legacy does disappear, he really only has himself ultimately to blamenot Democrats. That may seem counterintuitive or even unfair given that Bush is the biggest tax-cutter since President Reagan. But consider these four ways in which the president has inadvertently planted the seeds for the demise of his own fiscal policies.
1) Failed to properly time the 2001 tax cuts. The 2001 law called for a sequence of successive rate reductions from 2001 until 2006. (The 2003 law finally made immediate the tax rate cuts scheduled for 2004 and 2006 under the earlier law.) Now if you are going to cut taxes to boost the economy, the worst thing you can do is gradually phase in the reductions. That approach creates the perverse incentive of encouraging people to delay or push back their income and economic activity to the lower-tax years. So instead of strong economic growth, you're likely to get weaker growth at first. "If you delay tax cuts like that you are asking for a recession," Pat Toomey, president of the Club for Growth, told me recently. (This may well have been the case in the 1980s with the Reagan tax cuts.) Indeed, a 2006 study by Christopher House and Matthew Shapiro has concluded as much about the 2001 cuts:
" The phased-in nature of the tax cuts under the 2001 law contributed to the slow recovery from the 2001 recession, while the elimination of the phase-in in 2003 helps explain the sharp increase in economic activity in the second half of 2003. ...The phase-in under the 2001 tax bill gave firms and workers an incentive to delay production during the period of the phase-in. By accelerating the tax cuts scheduled for 2006, the 2003 tax bill gave firms and workers an immediate incentive to produce. Our model suggests that these incentives were large enough to account for a substantial amount of the behavior of actual GDP from 2001 to 2004. The slow recovery from the 2001 recession and the sudden increase in economic activity in mid-2003 are exactly what the model predicts in response to the time path of the tax rates."
2) Failed to make the 2001 tax cuts "growthy" enough. The 2001 cuts weren't just about promoting economic growth. They also had a social agenda, such as strengthening familiesvia "marriage penalty" relief and big increases in the child tax creditand helping lower-income Americans with a new 10 percent rate bracket. As the conservative Heritage Foundation puts it, "These provisions may have noneconomic merits, but they largely do not improve incentives to work, save, and invest." But what the post-stock market bubbleand later post-9/11economy needed back then was growth. "That's a fair criticism," says Cesar Conda, Vice President Dick Cheney's former assistant for domestic policy and now an economic policy adviser to 2008 GOP hopeful Mitt Romney. "The tax cuts weren't as pro-growth as some would have liked."
For growth purposesthough perhaps not for getting Bush elected in 2000it might have been better had the 2001 income-tax cuts and 2003 investment-tax cuts on capital gains and dividends been reversed. Tax cut advocates consider the capital gains taxes to have, dollar for dollar, more economic punch. If they had come first, perhaps the economy would have kicked back into gear earlier, making cause-and-effect seem more obvious to voters. In addition, capital gains taxes have a much better record of paying for themselves. Instead what voters saw was a big tax cut in 2001, lousy growth in 2002 and 2003, and the budget surplus turn into a big deficit that is only now shrinking. "So not only did those tax cuts not seem to work," Toomey said, "they seemed to be counterproductive."
Cutting capital gains taxes tends to be a hot political issue since many Republican view them as perhaps the most harmful of all taxes and many Democrats view them as the best of all taxes from a fairness perspective since they directly hit wealthier Americans right in their fat portfolios. And the exact effect that capital gains taxes have on economic growth is controversial. Yet here is what then Federal Reserve Chairman Alan Greenspan said about capital gains taxes back in 1997:
"If the capital gains tax were eliminated ... we would presumably, over time, see increased economic growth which would raise revenues for the personal and corporate taxes as well as the other taxes we have. The crucial issue about the capital gains tax is not its revenue-raising capacity. I think it is a very poor tax for that purpose. Indeed, its major impact is to impede entrepreneurial activity and capital formation. While all taxes impede economic growth to one extent or another, the capital gains tax is at the far end of the scale ... the appropriate capital gains tax [is] zero."
As it so happens, President Clinton signed a capital gains tax cut in 1997. In the eight full quarters before it took effect, the economy grew by $563 billion or 70 percent. In the eight full quarters after it took effect, the economy grew by $853 billion or 98 percent. Likewise, in the eight full quarters before the 2003 capital gains tax cut took effect, the economy grew by $251 billion or 25 percent. In the eight full quarters after it took effect, the economy grew $789 billion or 78 percent.
3) Failed to control spending. The federal budget was in surplus to the tune of $128 billion in fiscal 2001 as Bush took office. Since then, the government has racked up hundreds of billions in new debt. Tax cuts on wages such as those enacted in 2001 have certainly reduced tax revenue from the level it would hypothetically have reached absent tax cutsif you assume no effect on economic growth. Yet despite those rate cutsor because of them and the economic growth they spurred, the White House and some economists would arguerevenues are up $551 billion or 27.8 percent since 2001. And at 18.4 percent of GDP, federal tax revenues in 2006 were a bit above historical averages. But while revenues have risen smartly, spending has gone up nearly twice as fast, increasing by $851 billion, or 45.6 percent. With education spending up 129 percent since 2000, farm spending double that of the 1990s, a new trillion-dollar prescription drug entitlement and the most expensive highway bill, it's not surprising that federal spending has grown twice as faster under Bush as Clinton, according to calculations by Heritage analyst Brian Riedl. Had Bush controlled spending, the budget would already be back in surplusthough it may get there by 2009instead of still being 1.9 percent of GDP, which would a) make it tougher to link tax cuts to deficits; and b) make it tougher to argue that higher taxes are needed to bring down the deficit. It's worth noting that the two big tax hikes of the past 25 years, in 1982 and 1993, were policy responses to big budget deficits.
4) Failed to reform entitlements. Even if the current budget is balanced, the looming explosion in Social Security and Medicare costs serve as a handy reason to raise taxes by letting Bush's tax cuts expire. Here is how U.S Comptroller General David Walker describes America's long-term fiscal outlook in a recent report: http://www.gao.gov/new.items/d07362sp.pdf
"The present value of the federal government's major reported long-term "fiscal exposures"liabilities (e.g., debt), contingencies (e.g., insurance), and social insurance and other commitments and promises (e.g., Social Security, Medicare)rose from $20 trillion to about $50 trillion in the last 6 years ... Continuing on this imprudent and unsustainable path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our domestic tranquility and national security."
Now you can question many of the fiscal assumptions in such analysisas I have here but such huge numbers are a PR nightmare for tax-cut proponents. As a result, Bush's failure to achieve Social Security reformmuch less the even more difficult problem of healthcare reformmeans not only failing on what was supposed to be the major domestic policy initiative of his second term but it may also play a role in the reversal of the major domestic policy success of his first termthe tax cuts. But shouldn't Bush get loads of credit for even trying to deal with the so-called "third rail" of American politics? Sure, I guess. But such reasoning reminds me of college basketball coaches who schedule their squads to play loads of top-ranked teamsand then lose to them all. What, in the end, is the point? Bush should have probably focused less on telling Americans that Social Security was in "crisis" and more on telling younger workers what a bad financial deal it is for them, while also assuring seniors that the benefits under the current system were safe.
And what if the Bush tax cuts disappear? As I noted in "What's Worse, the AMT or a Recession?" investment firm Goldman Sachsusing the highly regarded Washington University Macro Modelran a simulation that assumed all the Bush tax cuts expired in 2010. According to the WUMM model, the economy fell 3 percentage points below what it would have been otherwiseeven assuming massive Federal Reserve rate cuts.
"Absent a tailwind to growth from some other source," the analysis concludes, "this would almost surely mark the onset of a recession." Question the model, but it sure seems logical that a sudden $400 billion tax increase in 2011 and 2012 might have some slowing effect on the economy. Now to be fair, the WUMM model does show that eventually the additional revenue would help balance the budget, leading to stronger longer-term growth. But as economist John Maynard Keynes famously commented, "In the long run, we are all dead."
And so, it seems likelyunless the budget is showing a big surplus in 2010are the Bush tax cuts.