The Tax Cut: Smile Now, Worry Later

Now that the $1.35 trillion tax cut is law and the emotional hoopla surrounding its passage is over, a closer look at the unprecedented bill reveals what may be a startling paradox: The big supply-side impact of the marginal, long-term cuts to income-tax rates will probably be less than predicted, and the smaller, Keynesian kick of the front-loaded rebates and withholding will be greater than expected. To policymakers worried about the current downturn, the unexpected stimulus is good news. But for investors and businesspeople and even consumers looking out to the future, the tax bill may well be disappointing. It dribbles out tax cuts, skips years, and automatically reverses itself in 2011. This uncertainty undermines its macroeconomic benefits. Smaller, permanent, predictable tax cuts almost always have bigger effects on investments than larger, uncertain, and possibly temporary tax cuts. A better tax bill would have put the surplus to better economic purpose.

First, the good news on front-loading. Thanks to pressure from Treasury Secretary Paul H. O'Neill, a one-time rebate check will be in the mail starting in July for $600 to all married taxpayers and $300 for singles. This reflects a cut in the bottom income-tax bracket from 15% to 10%, retroactive to Jan. 1, and puts serious money in the hands of some 110 million taxpayers, most of them low- and middle-income taxpayers, who are likely to spend it. It also does so much earlier than expected and in a form--a check--that many will find conducive to spending. When you add in the one-percentage-point cut in all other brackets this year, effective July 1, that will show up in lower withholding payments by September, it is clear that Washington is generating a powerful $45 billion wave of stimulus for the third quarter. An additional $65 billion will be injected next year. Together with the dramatic cuts in interest rates by the Federal Reserve, the front-loaded tax cuts greatly help brake the downturn.

But the tax plan was supposed to do much more: sharply change incentives and stimulate growth, thereby providing more tax revenues to pay for defense, education, and Social Security and Medicare reform. Accomplishing this, of course, requires predictability and consistency. These factors are lacking in the tax legislation. The law says that after the one-percentage-point cut this year, top-bracket taxpayers must wait three years, until 2004, for a cut to 37.6%, then two years, until 2006, for a cut to 35%. And, believe it or not, the bill says everything automatically reverses in 2011, with the top rate jumping back up to 39.6%. This sunset provision also applies to the estate tax, which ends in 2010, only to revert back to current law (55% for estates over $1 million) in 2011. The marriage penalty returns as well. This uncertainty surrounding the tax code sharply reduces its effect on incentives. Will this scheme survive five Congresses and two Presidential elections intact? Perhaps. Will politicians running for Congress in 2008 extend the tax bill beyond 2010? Maybe. But who is actually going to make investment and spending plans based on it? How can people make plans to pass on their businesses or their financial assets to their children under these uncertain conditions? No wonder professional estate planners are telling their clients to be cautious about the tax bill.

The great surprise of the Bush tax bill is that at the bottom end, it delivers. But at the top, where investment decisions are made, is a huge question mark. As Washington politicians celebrate their tax-cut victory, economic decision makers may soon discover it changes their lives very little, if at all. Indeed, with all the phasing in and out of tax cuts and grab bag of credits based on the vagaries of political winds, the bill itself may make doing business and planning a family's financial future more confusing and difficult.

    Before it's here, it's on the Bloomberg Terminal.