When Congress returns in January, President George W. Bush is almost certain to propose an economic-stimulus package that includes a heavy dose of tax cuts. Yet already, even without the Bush plan, the nation's budget deficit is expected to soar past $200 billion in current fiscal year 2003.
That collision of big tax cuts and ballooning deficits has set the stage for an acrimonious debate over how large a tax cut the U.S. can afford and whether the positive effects of lower taxes can outweigh the negatives of deeper deficits. Along with the prospect of war with Iraq, tax cuts vs. deficits will be one of the defining political and economic issues of 2003.
Predictably, the fight is breaking down along party lines. Most Republicans, even if they abhor big deficits, will eventually line up behind the Bush plan. Likewise, tax cuts will be attacked by Democrats on the grounds that they create bigger deficits.
Lost in the political dogfight, however, is the critical economic question: What provides a bigger boost for the economy, tax cuts or deficit reduction? The debate has raged among economists since at least 1980, when then-Presidential candidate Ronald Reagan proposed big tax cuts. Supply siders contend that cutting tax rates can unlock forces of long-term growth powerful enough to compensate for bigger deficits. Deficit hawks hold that big federal budget gaps drain vigor from the economy, even with lower tax rates.
Over the past 20 years, economists have learned a lot about the relative impact of tax cuts and budget deficits. But the real advances in knowledge have been obscured by the tendency of partisans on both sides--including economists who should know better--to make exaggerated claims.
The bottom line: At today's levels, income taxes aren't a big burden on long-term economic growth. Similarly, while the budget gap may seem large in absolute terms, it's far below the share of gross domestic product that has historically triggered problems. Once the overheated rhetoric is cleared away, Washington has the flexibility to shape a fiscal-stimulus bill that addresses the needs of the sluggish economy. Here's a primer on the issues that will help sort through the truths, half-truths, and exaggerations in the coming debate.
Let's start with the basics: Have federal income taxes been going up or down over the long term?
Surprisingly, the long-term trend in the income tax has been more or less flat. Over the past 30 years, federal income tax has generally absorbed 8% to 9% of GDP. When it goes much above 9%, as it did in 1981 and 2000, it creates political pressure for tax cuts. When it drops below 8%, as it did in the early 1990s, that opens the door for tax hikes.
Over the past year, with part of Bush's 2001 tax legislation already in effect, federal income taxes have fallen to 8.6% of GDP, right around the 30-year average of 8.4%.
If income taxes are not overly oppressive today, what are the economic arguments for further cuts in tax rates?
In the short term, tax cuts clearly pump up the economy by putting more money in consumers' pockets. It does matter, however, which taxes are cut. Lowering taxes paid by high-income filers is likely to hike savings, which could give an upward jolt to the stock market. In contrast, a cut in the Social Security payroll tax paid by employees would mostly benefit low-income workers, who are more likely to spend it quickly.
The more difficult question, though, is the impact of tax cuts on long-term growth. The core of supply-side theory is that people are discouraged from working harder, investing in themselves, and taking risks if they have to give much of their additional income to the government in the form of taxes.
Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
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