What's the right economic policy for incoming President George W. Bush to follow now? The Fed's deep interest rate cut has clearly removed much of the immediate need to give the economy a fiscal boost by reducing taxes. Still, with a budget surplus now projected by the Congressional Budget Office to be nearly $5 trillion over the next 10 years and Federal Reserve Chairman Alan Greenspan apparently signaling that the economy is weakening, it seems almost a sure thing that Bush will propose a substantial tax cut.
When it comes time to decide the precise nature and size of those decreases, it will be important to go for a tax cut that supports economic growth and works in tandem with monetary policy, rather than against it. Consider that the 1990s boom began not with a tax cut, but with President Bill Clinton's 1993 hike on top income-tax rates. At the time, supply-siders were absolutely convinced that the increase would set the stage for a recession--and said so loudly and emphatically.
How wrong they were. Instead, the tax hikes helped turn a federal deficit into a surplus that no one expected as the economy boomed. The diminishing threat of big budget deficits and looming inflation, in turn, made it much easier for Greenspan to hold down interest rates. No one likes high taxes, but big tax cuts made at the wrong time--and for the wrong reasons--won't benefit the U.S. economy.
BUSINESS WEEK believes, along with Greenspan, that the first thing to be done with the surplus is to pay down the debt--another way to "return money to the people." This would reduce debt-service spending in the federal budget, lower interest rates, and stimulate business investment, which has been the major force behind the New Economy boom.
If it is unwise or impossible to protect the whole surplus, then we are with Greenspan again in choosing tax cuts over spending increases. But Bush's campaign proposal, with its large-scale, backloaded cuts, is no model for a reasonable fiscal stimulus. A big tax cut of the kind that Bush seems to advocate would put upward pressure on inflation and interest rates precisely as companies are struggling for capital. Instead of pumping up the economy, it might actually make things worse, since it would be more difficult for the Fed to reduce rates further. Both academic research and recent experience suggest that monetary policy is far more potent than fiscal policy in dealing with downturns--so anything that makes it more difficult to cut interest rates is a bad thing.
Instead, the best alternative to a large-scale tax cut is to reduce marginal tax rates moderately, while at the same time trying to simplify the tax code as much as possible. That would serve the goal of encouraging investment while giving the Fed the room that it needs to keep cutting interest rates.