Commentary: What If You Had to Fix the Mess?

There's no free lunch: Cutting taxes without cutting spending creates enormous budget deficits

By Peter Coy

Imagine that it's January, 2003. The economy has weakened. It's your job to craft the best fiscal policy to get things revved up again without breaking the budget. You don't need to take politics into account. (This really is an alternate universe.) What to do?

Tough choices lie ahead. You'll need to decide whether to emphasize reviving the economy right away or improving conditions for long-term growth. If you pick short-term stimulus, you'll have to choose whether to spend money on boosting consumer spending, business investment, or job growth. "Be clear on what it is we're endeavoring to do," Federal Reserve Chairman Alan Greenspan said last year.

There's a good case to be made for doing something in the short term--especially by getting more money into consumers' pockets. The economy is running far below its potential, and the Bush Administration proved last year with its tax rebates that the government can inject stimulus quickly enough to ameliorate a downturn. The long term is vital as well, of course--but the arguments are trickier there. While big, permanent tax cuts encourage work and investment, recent research shows those gains can be outweighed by the drawbacks of bigger budget deficits.

But that's jumping the gun. Let's start by looking at your options. In the short term, your best target is probably consumer spending. Consumers account for 69% of gross domestic product. If people keep their wallets shut, businesses will cut back investment even more. That's why Goldman, Sachs & Co. economist Jan Hatzius advocates cuts in personal income taxes, which help keep consumers spending even as they increase saving to compensate for stock-market losses.

But who should get the cuts? Politics aside, the best way to boost consumer spending is to aid families in the lower half or so of the income distribution. That's because higher-income families save most of their tax cuts, which reduces their stimulative effect. You might want to temporarily cut rates for the bottom two income brackets. In addition, to help the 50 million filers who that don't pay income tax, you could send out rebate checks or cut the employee-paid portion of Social Security and Medicare payroll taxes. And it makes sense to extend unemployment benefits.

In contrast, the Bush Administration's concept of moving up the 2004 and 2006 tax cuts to 2003 isn't a cost-effective short-term stimulus, since the vast majority of tax cuts will go to high-income families that save them.

You might want to juice up business investment a little as well. Both faster depreciation and investment tax credits make it easier for companies to buy equipment and software. For a quick spurt, it probably makes sense to do some of each--temporarily. A recent paper by economists from the Federal Reserve and the American Enterprise Institute for Public Policy Research concluded that temporary tax cuts for business investment this year "provided more immediate stimulus than a permanent tax cut would have."

Think, too, about new incentives for companies to hire or keep workers. Tax cuts won't help consumers if they lose their jobs--and unemployment is apt to keep rising in 2003 as companies cut costs. A quick way to make employees less costly is to cut the employer-paid portion of Social Security and Medicare payroll taxes. Senator Joseph I. Lieberman (D-Conn.) has proposed a "new jobs tax credit" to reduce payroll taxes for companies that increase employment soon.

Many economists argue that such quick fixes don't work. "Micromanaging stimulus is Washington being too clever by half," says Stephen J. Entin, president of the Institute for Research on the Economics of Taxation.

That means you should think about long-term measures as well. What works? University of Michigan tax expert Joel Slemrod says permanent business tax cuts clearly raise business investment. Likewise, permanent cuts in capital gains taxes would encourage entrepreneurs to build companies, says Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc., a Chicago investment bank. And highly paid people might work harder if they didn't have to pay almost 40 cents of their last dollar earned in federal taxes.

Unfortunately, there's no free lunch. Cutting taxes without cutting spending creates enormous budget deficits, which could crowd out productivity-enhancing business investment. For instance, making the Bush tax cuts permanent would cost $4 trillion between 2011 to 2020, leaving aside the aid to growth from lower taxes and the drag on growth from bigger deficits.

Tax cutters who say deficits don't matter point out that long-term interest rates have fallen even as the budget picture worsens. But markets are fickle. The fact remains that running chronic deficits "is putting off the day of reckoning," says Slemrod. "In the long run, the market will force you to either cut spending or raise taxes," says University of Chicago Graduate School of Business economist Austan Goolsbee. Harvard University economist Benjamin Friedman says Reagan-era deficits crowded out business investment, while Clinton surpluses helped trigger the capital spending boom of the late 1990s.

If the economy is weaker in January, you'll want to take firm action on the fiscal front. If you choose short-term measures, particularly to support the consumer, you'll give the economy a boost when it's needed. And because your incentives will end soon, they won't add much to the debt. In contrast, permanent tax cuts would have less immediate impact, while adding to the debt that saps vigor from the economy. The choice seems clear. But, hey, it's your decision.

Coy is Economics Editor.

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