Tax cuts do work – but only for a while

The host of tax cuts enacted by Congress and the Bush administration since 2001 have done the economy some good. But not as much good as Republicans sometimes claim, other experts say.

For instance, House Education Committee Chairman Howard McKeon (R) of California credits Republican policies for steady job growth, higher wages, a lower unemployment rate, and cutting the budget deficit in half.

Here's an attempt to sort out a politically controversial topic.

Faced with a recession, a large federal budget surplus, and an already loose monetary policy, Republican lawmakers in 2001 did what any new regime would probably have done under the circumstances to prevent the economy from slumping further: They cut taxes.

The 2001 tax cuts "provided a short-term boost" to the economy, says Alan Viard, an economist at the moderately conservative American Enterprise Institute in Washington, D.C. By leaving more money in the hands of consumers and businesses, the cuts stimulated demand for goods and services.

But those initial cuts – as well as later tax-relief measures that lowered individual income-tax rates, estate taxes, and taxes on capital gains and dividends – also sparked criticism. Liberal economists chastised Republicans because the bulk of tax savings went to the well-to-do.

"The tax cuts worked for their primary purpose – to shift money upwards to people with a lot of money," charges John Schmitt, an economist with the Center for Economic and Policy Research, a liberal Washington think tank.

Aside from the issue of fairness, Mr. Schmitt says the cuts were inefficient. Millionaires spend some of their tax savings, but they spend proportionately less of them than do those in the bottom two-thirds of the income ladder, Schmitt notes. A one-time tax credit worth $300 to $500 for all taxpayers would have given a bigger bang for the lost revenue buck, he says.

Supply-side economists, influential in Republican circles, maintained that the tax cuts would stimulate savings and job-creating investment, and thus boost economic growth over time.

But critics say that the recovery since 2001 has been weaker than usual. "It's the worst performance in growth of any [business] cycle since 1961," says Paul Kasriel, economic research director at Northern Trust Co., in Chicago.

Personal savings have sunk to record lows. The tax cuts also have added about $2.3 trillion to federal deficits between 2001 and 2006, according to the Congressional Budget Office. The deficit in the fiscal year just ended was $71 billion less than in 2005, crows Mr. McKeon.

But the share of national income that went to wages and salaries in the first half of 2006 was at its lowest level since at least 1929. The share of corporate profits was at its highest level since 1950, perhaps accounting for the husky rise in stock prices.

September's weekly earnings after inflation were down from 2003, but up 2.2 percent from a year earlier. That's less than the average annual gain in post-World War II recoveries of 3.6 percent. And US job creation this decade is slower than in the European Union.

To Mr. Viard, the longer-term impact of the tax cuts, if they are extended permanently, depends on how the resulting budget deficits are financed. With baby boomers starting to claim Social Security in large numbers in 2008 and Medicare in 2011, he expects any future government will need to tackle rising deficits.

If it slashes spending, the tax cuts should boost the economy modestly. Viard cites a recent "dynamic analysis" by the US Treasury that sees a 0.7 percent increase annually in the level of national output above what it would otherwise be. But if the deficits are financed by tax increases, output would sink.

By now, most economists doubt that tax cuts pay for themselves by stimulating the economy so much that revenues grow rapidly. A new Congressional Research Service report, for example, finds that the stimulus effects of the Bush tax cuts have faded, and the negative effect of added debt service has grown. In the first 10 years, those additional debt-service costs can add 25 percent in lost revenues to the original tax-cut revenue losses. So in the long term, tax cuts add to the deficit.

As for the future of the economy, the Federal Reserve's monetary policy may well be more important than fiscal policy. Mr. Kasriel notes that, despite a big tax increase in 1993, the economy boomed in the second half of the 1990s. The pro-tax cutters "cherry-pick" their data, he says. Kasriel worries that slim growth today in the nation's money supply (the fuel for the economy) will weaken the economy further. Next month, he will accept the top award from Blue Chip Economic Indicators for his 2002-05 forecasts. (Blue Chip is a private group that tracks economic forecasts.)