Sometimes, the short term seems so urgent that we forget about the long term. More often than not, the electoral cycle makes politicians the chief offenders.
The latest example is the 2003 tax package, officially totaling $350 billion over 11 years. It is the Bush Administration's third round of tax cuts in three years and the largest since the record reductions of the Reagan Administration in 1981. For now, it seems to offer just what a beleaguered economy needs most, a healthy dose of stimulus to jolt demand. But in the next 11 years, how much growth will the economy have to give back as a result of these measures?
The question stems from the enormous budget deficits the Bush tax cuts threaten to create (chart). Economists generally believe Washington will rack up yearly deficits of about $400 billion from fiscal year 2003, which ends on Sept. 30, through fiscal 2005. That's about 4% of gross domestic product, compared with a surplus of 1.3% in 2001.
After 2004, the deficits could be even greater than the official numbers imply. That's because all but one of the provisions in the package are designed to expire between the end of 2004 and 2008. The politically expedient temptation for Congress to extend these "sunset" conditions rather than end the tax benefit will be great. If all of the provisions were extended, the additional 11-year cost of the cuts could soar to more than $1 trillion, according to the Center on Budget & Policy Priorities. The long-run concern for economic growth is that soaring deficits threaten to lift long-term interest rates.
IT'S A PROCESS economists call "crowding out." At any given time, there's a fixed pool of national savings available for businesses to borrow to expand or enhance their efficiency. When Washington needs to finance huge deficits, it scoops up funds that would otherwise be used for private investment. This crowding out raises long rates and stifles investment, reducing productivity and potential economic growth.
Federal Reserve Chairman Alan Greenspan addressed this issue head-on during his May 21 testimony to the Joint Economic Committee. In response to a question on deficits and rates, he said: "Indeed, changes in the longer-term fiscal outlook are very clearly a factor in the level of long-term interest rates."
How big a factor? Economists have tended to disagree on the magnitude of the crowding-out effect. Too often, their arguments get bogged down in political biases and in the failure of studies to isolate the effect of deficits on interest rates from other influences on the economy and rates at any given time.
Greenspan, however, made note of a May Fed study that attempted to isolate the link between deficits and long-term rates by looking not at actual deficits and interest rates but at expectations of future deficits and rates. Expectations are less affected by all the short-term factors influencing the economy. In the study, deficit expectations were based on projections by the Congressional Budget Office and the Office of Management & Budget, while rate expectations were derived from forward rates that existed when the deficit projections were published.
The study concluded that for every one percentage point increase in the ratio of the deficit to GDP, long-term rates rise by roughly one-quarter of a point. That is, if federal finances swing from a surplus of 1% of GDP to a deficit of 4% by 2005, long rates will be 1 1/4 points higher than they would otherwise be. That's enough to have a measurable impact on economic growth (chart).
Bear in mind that as the economy begins to pick up, long rates will start to rise on their own. On top of that, rate expectations will change to reflect the huge number of bonds that future deficits will require the Treasury to issue. That second premium in rates will boost the cost of capital and reduce the potential gains in business investment. It also will lift the cost to consumers for home buying and mortgage refinancing.
FOR NOW, those concerns are far away. The economy is struggling, and the bond market has deflation uppermost in its mind. Given weak credit demand by businesses, heavy government borrowing -- or even the prospect of it -- will not roil the bond market anytime soon. That means low financing will remain a key support for the economy a while longer, even as the tax plan begins to boost growth by the second half.
That's because the plan's economic impact is "front- loaded." According to the Joint Committee on Taxation, 60% of the potential stimulus, some $210 billion, will hit the economy by the end of fiscal year 2004, while 83%, some $290 billion, will arrive by 2005 (chart).
Of course, not all of that money will feed straight into demand. Economists at UBS Warburg (UBS) estimate that a family of four earning $40,000 per year will save $1,050 in taxes annually over the life of the tax plan; at an income of $70,000, the saving doubles to $2,025; and at $300,000, the tax reductions jump to $7,000. But wealthy families spend a smaller portion of any increase in their incomes than lower-income households do. So the impact on total consumer spending will be less than it would have been had the package been geared toward lower- and middle-income taxpayers.
EVEN SO, ECONOMISTS generally agree the package will boost real GDP growth by about one percentage point in the first year after its enactment, with the biggest potential boosts kicking in during the third quarter of 2003 and in the second quarter of 2004.
Why those two quarters? By this July, Washington will lower withholding schedules and mail out rebate checks, reflecting an expansion of the child credit for lower income families. For the quarter, aftertax incomes will get a boost of about $30 billion. That's enough to lift consumer spending for the quarter by a full percentage point, measured at an annual rate, although some of the windfall will be saved. Come next April, taxpayers will receive refunds to cover the retroactive reduction in tax rates back to the start of 2003. That will give incomes a boost in 2004's second quarter.
Other provisions will also help out in the short term. Businesses will receive new allowances on depreciation and expensing of certain costs. The stock market should get a lift from reducing the top tax rate on both capital gains and dividends to 15%. Even the states will get some $20 billion in relief in the coming year.
Add it all up, and the Bush package might well be the shove this economy needs to generate a recovery that finally feels like one. But once growth starts to pick up, the current attractive interest-rate climate will most likely start to change. That means an end to the wave of mortgage refinancings as well as a slowdown in the housing market and a limit on capital-spending gains. As economists are quick to admonish, there is no free lunch. In the coming years, the Bush tax cuts will very likely prove that. By James C. Cooper & Kathleen Madigan