With the holidays coming, Congress and the President are now arguing whether, when, and how to bestow a tax cut. Herewith, a guide to the economics, the politics, and the seasonal risks.
In this opening round, both parties have accepted different versions of the same premise: that a tax cut would stimulate the economy. That assumption, however, is questionable economics. A tax cut that widened the budget deficit would be stimulative because it would increase total spending, but most economists think the economy has overdosed on that brand of stimulation.
Indeed, if a large increase in the deficit spooked the bond market, it could be a net economic loss. On the other hand, a "deficit-neutral" tax cut -- the more likely outcome -- would be only mildly stimulative, depending on who received it and how the revenue loss was offset.
There are sharp ideological divisions between the parties. The Republicans, especially the Jack Kemp/supply-side wing, argue that capital-gains cuts would be the most effective recovery tonic, because they would boost investment and growth. They even contend that such cuts would mostly pay for themselves. By sheer repetition, supply siders have widely implanted the idea that a capital-gains tax cut is by definition a growth measure. This claim, however, is growing threadbare. In a recent speech in Boston, Vice-President Dan Quayle announced on network TV that he was going to refer to the current downturn as the "Mitchell recession." Why? Because the Democrats, led by Senate Majority Leader George J. Mitchell of Maine, have failed to enact capital-gains cuts and are hence responsible for the recession. "Mitchell recession" does not exactly resonate as a convincing explanation.
SOAK THE RICH? Democrats, on the other hand, have seized on "middle-class tax relief" as a political winner. During the 1980s, the middle class did indeed end up with a net tax hike because of increases in payroll taxes and state and local taxes, while those in the top 5% enjoyed significant real tax cuts. If the choice is tax relief for the rich vs. tax cuts for the middle class, the middle class should win hands down. After being intimidated by rhetoric branding them as the soak-the-rich party throughout the 1980s, the Democrats last year began waking up to the fact that soak-the-rich might not be bad politics.
A year ago, the Democratic congressional rank and file revolted against the leadership's budget deal, demanding revisions that did more for the middle class and hiked taxes slightly on the well-to-do. Next, Representative Thomas J. Downey (D-N.Y.) and Senator Albert Gore Jr. (D-Tenn.) sponsored legislation that would give tax relief to working families, substituting a refundable tax credit for the current personal exemption. To pay for it, Downey-Gore adds two new top brackets. On balance, some 134 million Americans would get a tax cut -- but 15 million would get increases. The plan would be deficit-neutral.
House Ways & Means Committee Chairman Dan Rostenkowski (D-Ill.) initially resisted this approach as busting the Tax Reform Act of 1986, which he co-authored, and as inviting Christmas-tree amendments. But in October, "Rosty" offered his own variation on middle-class tax relief paid for by increasing taxes on the rich. Rostenkowski would give wage earners a $400 credit against Social Security taxes and pay for it by adding new top brackets. "If you're a middle-class American, you get a tax cut," said Rosty, the workingman's friend. "If you're in the top 1%, you get a tax increase."
GLITCHES. This approach, also deficit-neutral, would arguably be stimulative because wage earners would be more likely to rush out and spend the money -- but at best it would be only mildly stimulative because it would withdraw income from the well-off, who are also pretty fair spenders. Even though the Rostenkowski approach seems better politics -- and perhaps better economics -- than Dan Quayle's, several glitches are evident. The Democrats are by no means united. Senate Finance Committee Chairman Lloyd Bentsen (D-Tex.), for one, is partial to an approach that would give a little something to everybody: individual retirement account (IRA) inducements to boost savings, a little help for homeowners, a token children's tax credit, and perhaps even a dash of capital-gains relief. Speaker of the House Thomas S. Foley (D-Wash.), for another, has signaled that he might well split the difference with the President in order to get a bill.
As a recovery measure, increased borrowing to finance public investment would be far better than either capital-gains relief or even middle-class relief, since all the money would directly stimulate the economy. But the coming debate is unlikely to produce either clear political choices or sound economic policies. Rosty is right to be worried that Christmas is coming. With Congress and the White House competing over who can provide the first, most, and best tax relief, there is a risk that the eventual bill will muddy the differences between the parties, cost the Treasury a lot of money, and not necessarily even stimulate the economy. Everybody, sing: Deck the halls with boughs of folly....Bah, humbug.