How to Wage War and Help Economy

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

October 27, 2001

The United States now faces two economic challenges: how to hasten recovery
from a severe recession and how to pay for a long and costly campaign against
terrorists. The two problems call for two solutions. Short-run tax and spending
measures to boost private and public spending will help fight the recession.
Long-run belt-tightening will help pay for the antiterrorist campaign and avoid
returning the nation to an era of growth-retarding federal deficits.

Unfortunately, the House of Representatives seems to be on its way to passing
large and permanent tax cuts, largely for business and upper-income individuals,
that will loosen our fiscal belts a few more notches.

All doubt that the nation is in recession vanished with the destruction of
the World Trade Center and damage to the Pentagon. If households curtail
consumption even modestly, the recession will be deep. If the loss of
consumption ripples through to jobs, incomes, and investment, the recession
could be extremely painful.

The policy goal should be to keep the recession brief and shallow. The way
to do so is to quickly spur household consumption and business investment.
Eventually, the Federal Reserve’s expansionary monetary policy is likely to
stimulate both consumption and investment. But monetary policy is slow to act.
Meanwhile, fiscal policy tax cuts and spending increases can boost spending, but
they can do so only if personal tax cuts are aimed at people who spend most of
what they receive and if business tax cuts are linked to investments put in
place within the next 12 to 18 months.

This goal to raise spending now means that cuts in capital gains taxes or in
corporate tax rates should take second place to accelerated depreciation or
deductions linked to new investment. It also means that investment incentives
should not apply to investments put in place two or three years in the future.
And it means that personal tax cuts should be temporary and go to low- and
moderate-income families who spend most of their incomes.

Over the longer term, the fiscal challenge can be encapsulated in a simple
slogan: “Fight the terrorists first.” In 1999, as the prospect of fiscal
surpluses emerged, President Clinton stopped large tax cuts with the slogan:
“Save Social Security first.” This year a new president reversed that priority,
placing tax cuts ahead of Social Security reform. The horrific events of Sept.
11 have put before us an even more compelling challenge than reforming the
nation’s basic pension program.

While near-term deficits will help offset cuts in private spending, long-term
deficits slow growth by absorbing private saving and lowering investment. Less
investment slows introduction of new technology and reduces economic growth.
Deficits mean that funds from the general budget are unavailable either to close
projected Social Security deficits or to ease the transition to individual
accounts. They absorb funds that could be used to pay for a prescription drug
benefit for the elderly and disabled, to modernize our transportation system, or
do much of anything else.

Fighting terrorists costs money—lots of it. Money for arms. Money to shore
up damaged industries. Money to help workers displaced by economic dislocation.
Money to invest in buildings and equipment necessary to sustain growth of the
economy that will support the antiterrorist effort.

Whatever tax cut the United States could afford last May, it can afford less
today. A tax cut in the short run will help keep Americans at work. Over the
longer term, Americans must cinch up their belts and consume a bit less. That
means higher, not lower, taxes. It means that the permanent tax-rate cuts
enacted in May scheduled to take effect in 2004 should not be accelerated. They
should be suspended or scaled back. The phased repeal of the estate tax should
be canceled. The idea that very rich heirs should inherit millions or even
billions tax free while other Americans are making sacrifices is offensive.
Other tax reductions should be put on hold until the United States wins what is
bound to be a long and costly struggle.

These principles mean that most of the draft tax cut legislation recently
approved by the House Ways and Means Committee in the name of fighting the
recession is ill considered. It would accelerate tax cuts for the well-to-do
that should be suspended. It would provide business tax cuts that would
encourage investment mostly after the current recession has ended. It would
bestow windfalls on owners of capital.

The Ways and Means bill is a Faustian bargain, buying a dollop of needed
short-term stimulus with tens of billions of dollars of future deficits.
Nonetheless, the GOP majority in the House seems committed to passing the bill
in more or less its current form.

The Senate should reject this bill and start anew.

Its guiding principle can be simple fiscal stimulus now to speed economic
recovery and belt-tightening until we have paid for and won the fight against
the terrorists.