The case for letting Reagan's third tax cut ride

Some House Democrats are arguing that unless the final $28 billion, 10 percent income tax cut called for by the Economic Recovery Tax Act of 1981 is repealed, the huge federal budget deficit will force up interest rates, choking off the recovery.

Contrariwise, a proponent of maintaining this tax cut, Thomas Humbert, an economist with the Heritage Foundation, maintains that repeal would ''stifle the recovery now taking place.''

Who's right?

Neither one. ''The evidence I have seen, both theoretical and empirical,'' says Arthur E. Gandolfi, an economist with Citibank, ''shows that tax changes have little impact on the level of economic activity.''

Over the last two decades, some economists have often predicted that a tax cut would stimulate the economy and a tax increase would dampen activity. Time after time they were wrong. The tax changes had little effect, or they were overwhelmed by trends in monetary policy.

This time also, whether or not Congress repeals the tax cut, the recovery will go on - unless the Federal Reserve System decides to slam on the monetary brakes.

If the tax cut is repealed, the deficit may be reduced - assuming Congress doesn't accelerate spending. Washington would have to borrow less. But the public would have less money available to save. So the effect on the money markets would be basically a wash.

If the cut is not repealed, Washington would have to borrow more. But the public would save more. Again, a wash.

In theory, if the tax cut stays in place, some financially hard-pressed individuals may spend some of the extra after-tax income rather than save it. But the impact on consumption would be so small that economists using fancy mathematical models and looking at earlier business cycles, have had a hard time sorting it out from other economic trends.

Further, such a step-up in consumer spending would be, as Mr. Gandolfi puts it, ''borrowing from the future.'' Eventually the government will somehow have to cover its deficits - through raising taxes, printing more money, and thus accelerating inflation (which reduces the value of outstanding government debt and raises taxes by putting people in higher brackets), or by extra borrowing. All these would eventually hit consumers in the pocketbook.

Even if the July tax cut won't do much for the recovery, there are several valid arguments in favor of retaining it.

The favorite one offered by Citibank's Mr. Gandolfi is the need for a stable economic environment for business and individuals. Companies find it difficult to make rational investment plans, particularly for the long term, if they cannot calculate their tax burden into the future. Mr. Gandolfi says a shortsighted approach to economic policymaking means that businessmen are leery about making long-term investments or demand higher returns from them. Individuals, making spending or investment plans for the next two or three years , may not be able to calculate their after-tax income within a range of several thousand dollars, assuming a steady after-inflation income.

Thus, an uncertain tax environment can damage the long-term, ''secular'' prospects of the economy - even though its effect on the business cycle may be minimal.

A political judgment of Mr. Gandolfi is that repeal of the tax cut would only mean that Congress would spend about another $28 billion. Congress is under extreme pressure at this time to step up social expenditures, he figures.

''Tax increases simply unleash more government spending, rather than stem the flow of budget red ink,'' says Mr. Humbert of the Heritage Foundation.

The government would spend more, individuals would spend or save less, and the recovery would roll on. But since Mr. Gandolfi believes the government takes too large a chunk of national income already, he would rather the tax cut went through.

Mr. Humbert offers several reasons for maintaining the cut:

* It would create jobs. This is the supply-side argument that the cut would stimulate business, particularly small business, which tends especially to create new jobs.

There may well be a supply-side effect over the longer run, but Mr. Humbert exaggerates when he says that ''the economic recovery hinges to a large extent on the July cut.''

* It would encourage saving. Repeal would slow the recent surge in individual new saving, which was up 30 percent in the third quarter of 1982, to 6.9 percent.

That could be, although if Congress didn't spend all the $28 billion of the repealed tax cut, the government would ''save'' more by not going so deeply into the red.

* It would foster productive investment. Without the cut, Mr. Humbert argues, some taxpayers might be tempted to withdraw money from taxable investments and shift it into tax-exempt bonds, tax shelters, or nontaxable consumption expenditures. Other taxpayers would have to take up more of the tax burden.

But the main reason that well-to-do taxpayers have had for losing some of their enthusiasm in tax shelters - the reduction in the maximum marginal tax from 70 percent to 50 percent, with most paying much less - would not change. It's hard to imagine a major shift back to tax shelters.

* It would shift the tax burden to the rich and help the average American. Mr. Humbert is using essentially the same argument - that the rich are willing to pay more taxes when tax rates are lower.

This has some logic, but may be hard to prove.

Perhaps the main argument Mr. Humbert presents is that so far the Reagan tax cuts have been offset by bracket creep and increased social security taxes for middle- and low-income taxpayers. This third cut, he says, will be the first real reduction in the burden for this group of taxpayers - the majority. The wealthy have already had their big break in the reduction of the marginal tax rate from 70 to 50 percent, he says, and will get relatively little from the next 10 percent cut. That effect on the rich depends on whether you look at percentages or actual dollar numbers.

In any case, there are some reasonable arguments for leaving the July tax cut in place. But its supposed impact on the cycle is not a valid one.

What the 3rd phase tax cut means to your tax bill (For a four-person, one earner family) Reduction in tax liability 1984 tax liability from 3rd phase Income without 3rd phase Amount Percentage 20,000 1,713 164 9.6 30,000 3,363 360 10.7 40,000 5,394 520 9.6 50,000 7,993 828 10.4 100,000 24,424 2,368 9.7 200,000 62,566 4,366 7.0 Source: Treasury Department