Making Choices: Exploring the Tax Issue

Alice M. Rivlin
Alice Rivlin
Alice M. Rivlin Former Brookings Expert

October 20, 2004

Sometimes tax reduction is the right medicine for an ailing economy, and sometimes it is a big mistake, like now. Our country is fighting a war and facing the retirement of the baby boom generation. Extending the full range of President Bush’s tax cuts into the indefinite future will create massive deficits that endanger economic growth and load the burden of current spending onto future taxpayers. Full extension would be a bonanza for the least needy among us, which makes an unaffordable policy even less defensible.

In a recession, cutting taxes can help get the economy going again, especially if the extra money goes to low- and moderate-income people, who tend to spend it quickly. The tax cuts enacted in 2001, however, were not well designed to fight recession. In the presidential campaign of 2000, when the budget was in surplus and no recession was expected, candidate George W. Bush promised the income and estate tax cuts espoused by the right wing of his party. Such tax cuts inevitably benefit the high-income taxpayers who pay the lion’s share of income and estate taxes. Candidate Bush argued this was fair. It was their money, and they would spend it better than the government.

By the time the 2001 tax cuts were enacted, however, the economy was in recession. A temporary reduction in payroll taxes paid would have put extra cash in the pockets of all wage-earners, including those who do not earn enough to pay income tax, but the income tax cuts were already rolling down the legislative track. The timing was fortuitous, and the tax cuts did help make the recession less severe. The so-called “rebate” and the tax relief to moderate-income families with children boosted consumer spending, while favorable treatment of equipment spending encouraged faltering business investment.

However, the tax cuts should not get full credit for reviving the economy. The Federal Reserve aggressively lowered interest rates beginning in early 2001, sustaining a surge of spending for housing, home furnishings and cars. Federal expenditures, especially for defense and homeland security, rose rapidly and boosted consumer and business spending. As equipment purchased in the boom years began to obsolesce and wear out, business investment turned back up again.

Whoever wins this election will face a federal budget outlook that is totally different from that of four years ago. The economy is growing again, but the projected budget surpluses that were the original rationale for President Bush’s tax cuts have been replaced by huge prospective deficits. Instead of paying down the debt, the government borrowed more than $400 billion (about 3.5 percent of the Gross Domestic Product) in fiscal year 2004, much of it from foreign lenders. On realistic assumptions, the government will have to go on borrowing around 3.5 percent of the GDP for the next decade. Moreover, as the baby boom generation retires and medical costs continue to soar, government spending for Social Security, Medicare and Medicaid is bound to rise rapidly, making the long-run deficit outlook worse, not better. The tax-cutters’ slogan, “It’s your money!” should be replaced by, “It’s your debt!”

No one knows how long lenders will be willing to absorb ever-increasing amounts of United States Treasury debt, but they are likely to demand higher interest rates to do so. Higher rates will mean more debt service to be paid by U.S. taxpayers, as well as higher rates on home mortgages, car loans and business borrowing, none of which is good news for the American economy. At some point, international investors (including American ones) could decide that our government was not behaving responsibly and begin dumping their dollar securities. Loss of international confidence in the dollar could trigger chaos in the markets and a serious recession.

Even if the world’s lenders let us continue borrowing, why should we want to shift trillions of dollars of debt onto our children and grandchildren? They are the workers who will have to support more and more long-lived retirees. We should not be self-indulgently adding to their burdens. Even the argument that the economy will grow faster at lower tax rates is unconvincing. Growth was high in the 1990s when tax rates were higher than they are now, and the higher interest rates that go with big deficits will be a drag on growth.

With a war to fight, the baby boom generation approaching retirement, and huge deficits looming ahead, we cannot afford the tax cuts that some thought affordable four years ago. Moreover, when people with skills, education and the right connections are doing well and low-wage workers are falling behind, tax cuts that benefit high-income and wealthy people are especially unconscionable and shortsighted. In short, extending all the tax reductions of the last four years, especially those that benefit the top end of the income distribution, is a bad idea.