The Tax-Cut Recipe for Ruin


By Howard Gleckman President Bush's top economic policy priority next year will be to make the 2001 tax cuts permanent. And with congressional Democrats both demoralized and outvoted, there's a good chance it will happen -- with potentially stunning consequences.

Such a step would fundamentally change the federal government. With the tax cuts permanent, Washington's red ink will only grow, and so will pressure to reduce basic Social Security and Medicare benefits. Then the tax system itself would have to be revamped. In many ways, making those tax cuts permanent will result in some of the most dramatic changes in government since the Great Society.

What the move won't do is help the current economy very much. The White House argues that locking those tax cuts in beyond 2010 -- when they're now due to expire -- will provide an immediate boost to growth. That claim is just silly. No credible evidence shows that cutting taxes in 10 years has any impact on economic decisions today. Even Federal Reserve Chairman Alan Greenspan, who has rarely met a tax cut he didn't like, says the growth argument is bogus. "I know there is a presumption that if you make those tax cuts permanent it will add stimulus to the economy," Greenspan told Congress on Nov. 13. "I doubt it."

SHRUNKEN SERVICES. Making the '01 bill permanent would lock in several key changes in the tax law. The biggest: lowering individual tax rates and repealing the estate tax. The latter alone would cost in excess of $50 billion a year in 2011.

If the tax cuts are made permanent, by 2020, the U.S. government will have to shrink. It may well be reduced to doing just four things: paying Social Security benefits, providing health care for the elderly and the poor though Medicare and Medicaid, supporting the national defense, and paying interest on the money borrowed to do the first three. That's it.

There would be literally no money left for education, law enforcement or homeland security, environmental and consumer protection, highways, air-traffic control, or any of the myriad of other things we've come to expect Washington to provide. Indeed, stripping the government to just that handful of functions would still leave the budget in the red.

FUTURE SHOCK. To understand why, here are a few numbers. Assume that defense costs remain at about 3% of gross domestic product -- which is well below the average for even the past decade. And figure no changes in Social Security, Medicare, and Medicaid -- not even passage of a Medicare drug benefit. In that case, doing just health, Social Security, defense, and paying interest on the debt is expected to cost roughly 19.5% of the nation's total economic output, according to the General Accounting Office. But tax revenues -- after the '01 cuts are locked in -- would bring in just 19% of GDP. Houston, we've got a problem.

Admittedly, this debate is somewhat theoretical. Nobody really knows how much revenue the tax system will generate in 10 years or 20 years. It may be a percent of GDP higher or lower. But you get the drift.

The debate is also a little fuzzy since never in the history of the income tax has the levy remained static for as long as a decade. The tax laws will be changed many times between now and 2010, and many times again before 2020. And, in the end, a permanent, growing structural deficit will be unacceptable. First, the bond market will revolt, pushing up interest rates. Then, the politicians will respond, probably by raising taxes. As the late economist Herb Stein once said, "If something cannot go on forever, it will stop."

Still, raising taxes is never easy in Washington. Once tax cuts are locked into place, hiking them in the absence of a crisis is a very tough sell. Since the crunch won't come until sometime in the next decade, it will be up to Bush's successors to deal with a tax system that increasingly will fail to bring in enough money to satisfy the demands of voters. Make no mistake: By making those tax cuts permanent, Bush will be leaving future Presidents with an especially nasty budget mess. Gleckman is a senior correspondent in BusinessWeek's Washington bureau. Follow his views every Tuesday in Washington

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