The Tax Hike Won't Derail The Recovery

Back in August, when President Clinton's five-year, $240 billion tax increase passed the Senate, critics predicted the worst. "Make no mistake," warned Senator Orrin G. Hatch (R-Utah), "these higher rates will cost jobs."

Well, a funny thing happened on the way to Armageddon. The economy, which was growing at an anemic 1.3% annual rate before the tax hike became law, expanded at more than twice that rate during the second half. What's more, economists figure growth reached 4% or more in the fourth quarter. And in the six months since Clinton signed the measure, nearly a million new jobs have been created, while personal consumption has grown by close to 4%.

Does all this mean that the road to economic nirvana is paved with tax hikes? Even self-promoting Clintonites don't believe that. But it does suggest that fears about the impact of a modest tax increase were overblown.

The 1993 law raised corporate rates, boosted the gasoline tax by a nickel a gallon, and whacked the wealthiest 1% with a hefty rate increase. But the biggest hits were retroactive to Jan. 1, 1993. The upshot? "If there was going to be a dramatic impact, we would have seen it," says Peter R. Merrill, a senior tax economist at Price Waterhouse.

GAMESMANSHIP. So what went right? The main reason the tax bill faded in macroeconomic importance was its small size. The measure's roughly $20 billion a year in individual tax hikes amount to less than 0.5% of personal income. That impact is dwarfed by bigger changes in the economy--namely, the cyclical upturn after nearly four years in the doldrums, and the sharp drop in interest rates.

Moreover, the tax rise may be even smaller than advertised. Analysts such as Harvard University economist Martin S. Feldstein argue that the measure will fail to raise much revenue because smart taxpayers will duck higher levies by shifting income to capital gains or buying bigger houses with larger mortgage deductions. Joel Prakken, an economist at Laurence H. Meyer & Associates, estimates that this gamesmanship will trim the Treasury Dept.'s anticipated receipts by 20%.

O.K., the law's critics insist, it didn't have much impact in 1993. But just wait until this year, when higher taxes show up in withholding and people file their '93 returns.

If the tax law hurt Joe Lunchbucket, this argument might have merit. But the targets of the measure are more sophisticated. Half of those who make more than $200,000 pay estimated taxes each quarter and would have felt its impact as early as last September. For them, writing a bigger check on Apr. 15 "won't come as a big shock," says Randall Weiss, an economist at Deloitte & Touche.

REINING THE FED. That said, was the tax increase a good thing? To the degree that it took money out of citizens' pockets and trimmed private savings, the answer is no. But if the measure helped forge a deficit-reduction plan that the bond markets found credible, it probably deserves some credit for 1993's falling interest rates. The rate drop may even offset much of the short-run drag of the tax hike itself. And the budget deal may have helped persuade the Federal Reserve to stay off the monetary brakes last summer.

The 1993 budget package would have been improved if the plan had included more spending cuts and fewer taxes. But with the Democrats in control of the White House and Congress, any budget measure had to include higher taxes on the rich. As it happened, this one came just as the economy started gaining momentum on its own--the best possible time to hike taxes. Just ask Ronald Reagan, who signed a much bigger tax increase in 1982--and watched the economy grow nonstop for six years.

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