Will We Feel the Tax Cut?

A slow phase-in means any economic benefits may be thin

The GOP Senate may be slip-sliding away. But despite the sudden change in George W. Bush's political fortunes, you can't take this away from the President: He stands on the brink of a political triumph in his battle for a sweeping tax cut. Whether it is also an economic triumph remains to be seen. That's because the proposal that will soon pass Congress represents a complex set of compromises that, in many ways, dilutes the economic punch of his marginal-rate reductions.

Outwardly, the measure closely resembles the plan on which Bush campaigned. But lawmakers struggled to fit his package into a $1.35 trillion budget envelope. And in the Senate, they aligned more of the cuts toward lower- and middle-income Americans. As a result, many upper-bracket tax breaks are being stretched out for so many years that it would take a GOP dynasty to cement them into law.

How come? The bill that passed the Senate on May 23 was laced with a series of phase-ins and phase-outs. Consequently, that plan--which will likely resemble the version that will be adopted soon by House and Senate negotiators--cuts some taxes immediately while delaying other provisions for as long as a decade.

A new 10% bracket for low-income families, for example, would be retroactive to Jan. 1, 2001. So would a small increase in the child credit. But hefty earners shouldn't look for big cuts soon: The top 39.6% tax bracket isn't set to drop to 36% until 2007. Provisions that would ease the marriage penalty would not begin to kick in until 2006 and would not be fully effective until 2011. And it will be nearly a decade before the estate tax is repealed.

As a result, the Senate bill includes tax cuts totalling only $270 billion by fiscal 2004. The bulk of the cuts, more than $800 billion, take effect between 2007 and 2011. "There are some very big things on the table," says Robert Bixby, executive director of the Concord Coalition, a budget-reform group. "But people don't have a sense of the time it will take for many of them to be accomplished."

Because so much relief for top-bracket taxpayers is delayed for so long, many of the benefits in the first few years go to low- and middle-income taxpayers. Folks earning under $40,000 would get one-third of all the cuts this year, says the Congressional Joint Committee on Taxation, while those making more than $100,000 would get only 2%.

The leisurely phase-in will also dilute some of the short-term economic impact. Only $20 billion of the Senate bill would actually get into taxpayer's pockets this year, barely a blip in a $10 trillion economy. Because the tax reduction takes over a decade to implement, its value in today's dollars is far less than if it occurred right away.

None of this diminishes Bush's political achievement. The final tax bill won't be the $1.6 trillion bonanza he fought for, but it is close enough for a momentum-building victory. "There's an old saying that goes, `It doesn't matter if you win or lose in Washington, so long as you win,"' says Republican pollster Bill McInturff. "The fact is, this cut is much bigger and is coming much sooner than anyone expected."

Moreover, it represents a big step toward another conservative goal: By draining more than a trillion dollars from federal coffers, it makes it tougher for Congress to continue to spend rapidly. Says Senator Joseph Biden (D-Del.): "This fight was about fundamentally changing the role of government, and Republicans are beating the devil out of us. Not only is the money gone, but once the rate cuts are locked in, they are very hard to eliminate politically."

Still, the long delays before tax cuts kick in may create both political and economic problems for Bush and the GOP, too. For starters, Hill Republicans who must run for reelection in just 18 months are not happy with slo-mo tax relief. "I'm concerned," says Senator John Warner (R-Va.). "My constituents are going to say, `Hey, wait a minute. I heard about this tax cut you passed. Show me the check.' There's no beef in this bun."

IFFY THEORY. A bigger disappointment may loom on the economic front. Backers of rate cuts didn't just argue that they would help short-term consumption, thus jump-starting today's slow economy. They also make the supply-side claim that tax cuts for wealthier individuals would increase savings and investment, which, in turn, would enlarge the pool of capital for business. Companies would use that cash to buy equipment, which would spike worker productivity and strengthen the economy. The result: another Reagan-type boom. Rate reductions, says Daniel Mitchell of the Heritage Foundation, "will boost economic performance by increasing incentives to work, save, and invest."

But economists continue to debate whether that theory lives up to its promise. While the economy soared after the massive Reagan tax cuts of 1981, plenty of the investment incentives in his bill were repealed before they ever took effect. And many economists are convinced that the growth of the '80s was really spurred by the Federal Reserve's efforts to crush inflation.

To add to the muddle, the economy boomed again after Bill Clinton raised taxes in 1993. "In the '80s, we cut taxes, and the economy grew. In the '90s, we saved the surplus, and the economy grew," says Brookings Institution economist William G. Gale.

In truth, tax rates may matter less to the economy's long-term performance than monetary policy, technological innovation, and global competition. That's especially true with individual rate changes, because it's hard to figure out how much will be spent and how much will be saved. "The evidence that anybody changes their behavior very much is sparse," insists Joel B. Slemrod, director of the Office of Tax Policy Research at the University of Michigan.

MUTED EFFECT. The current tax bill is especially tricky to gauge. For starters, the top-bracket cuts are small compared with Reagan's, which took the top tier down to 50% from 70%. And while Reagan's individual cuts kicked in over just three years, in this year's Senate bill it takes seven. "It just mutes the effects because it takes so long," says Alan J. Auerbach, a tax economist at the University of California at Berkeley.

More troubling to supply-siders: Many top-bracket trims could eventually be aborted by a future President and Congress. "When they are desperate to turn the economy around, they cut taxes," says Stephen J. Entin, a veteran of the Reagan Treasury Dept. "As soon as things get going, they take the money away."

History suggests that his fears are well founded. Despite his popularity, Reagan's 1981 tax cut was followed by tax hikes in '82, '83, and '84. It was a similar story in 1986. In the massive tax-reform act that passed that year, Congress slashed the top rate over three years, so that it hit 28% by 1988. But by 1990, then-President Bush moved his lips and bumped it back up to 31%. In 1993, President Clinton hiked it to 39.6%.

Before Dubya's bill is fully effective, there will be two Presidential elections and five congressional elections. Tax policy "will be changed many times over the next 10 years," says ex-Congressional Budget Office Director Rudolph G. Penner.

Nonetheless, some economists think the symbolism of the Bush tax cut is at least as important as the dollars it adds to people's pockets. The promise of the bill, perhaps more than its reality, could keep consumers spending. It could also perk up Wall Street by signaling to investors that lawmakers are willing to limit Washington's tax take, says Pierre Ellis, senior economist at Primark Decision Economics Inc. "It's a change in philosophy." Investors "can see that the [after-tax] return on investment down the road is going to be higher.'

Is there any way Bush can lock in these changes or even add to them? It will be a struggle. He is trying to placate both supply-siders and business by holding out the prospect of a second tax cut later this year. That could give the corporate crowd, left out in Bush's first swing at the tax code, a chance to push for liberalized depreciation and other breaks. Says the GOP's McInturff: "This bill is the camel's nose under the tent. If the economy stabilizes, we can come back for more cuts."

Trouble is, by draining much of the anticipated surplus over the next decade, today's tax cuts will not only squeeze spending but they will also make it tougher to find the money for more. And the expected decision by Vermont Senator James Jeffords to abandon the GOP will give Democrats control of the Senate, lengthening the odds against Bush winning another big tax reduction.

If an economic rebound lifts all boats, Bush's tax-slashing will look golden. Continued surpluses would provide the money to lock in today's tax cuts and enact future reductions. Even if the boom is not revived, tight budgets will help the GOP fend off Demo-crats' spending plans. That's precisely the kind of "heads Bush wins, tails our party loses" scenario that worries Democrats today even as they cheer their brighter Senate prospects.

By Howard Gleckman, with Lee Walczak and Lorraine Woellert, in Washington

— With assistance by Lee Walczak, and Lorraine Woellert

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