Now Is the Time for All Good Feds to Come to the Aid of States

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

December 20, 2002

Whatever emerges from the current tax cut debate in Washington, you can be sure that politicians will call it a stimulus package. But the tax cuts the Bush administration is promoting would fail miserably as stimulus. Some of them could make things worse.

Fortunately, there is a simple way to boost the economy now and improve future prospects as well.

We have had record amounts of stimulus in the last two years. The Federal Reserve has cut interest rates by 500 basis points, to the lowest level in several decades. Federal spending increased by 6%, and tax revenue fell by 13% as a share of the economy.

Although most economists believe that tax cuts are a poor way to boost the economy in the short run, the administration claimed that its $1.35-trillion tax cut in 2001 was an insurance policy against stagnation. Of course, the economic fallout from the Sept. 11 terrorist attacks could not have been forecast. Nevertheless, a mere two years later, we are left with only a sputtering economy and a vastly increased budget deficit. Now we are being asked to drink more tax-cut snake oil.

A new subsidy for business investment would generate little new activity; it would just pay companies to do things they would have done anyway. The cost of investing has already fallen dramatically because of the generous depreciation rules enacted this year and steep declines in interest rates and inflation. But investment has been flat or falling. Businesses already have more excess capacity than at any time in the last 20 years; why should they buy new plants and equipment when they are not even using what they own?

Likewise, tax cuts aimed at promoting saving work in the wrong direction. Raising the contribution limit on retirement savings accounts might boost saving a little, but it also would reduce spending. Expanding deductions for capital losses would encourage people to unload their losing stocks, generate a wave of selling and push the market down.

Cutting dividend taxes makes sense as part of a broader deficit-neutral effort to clean up loopholes and problems in the corporate tax, but not as stimulus. The stock market effect would be muted because half of dividends already escape income taxes. The stimulus would be even smaller because dividends go mainly to high-income households that probably would save the money.

Perhaps the silliest notion is that making the 2001 tax cut permanent—it is in effect through 2010—would boost the economy now. In fact, it would significantly raise estimates of long-term deficits and increase uncertainty about Social Security and Medicare. This would raise interest rates now and hurt the economy.

Another option being talked about is immediate tax cuts for consumers. But the 2001 rebate appears to have been very weak medicine; it barely shows up in the aggregate spending figures. Phasing in the upper-income tax-rate cuts scheduled for 2004 or 2006 would provide little help to households in the bottom 60% of the income distribution, which would be most likely to spend the money. Accelerating the expansion of the lowest bracket or the child credit or cutting payroll taxes would probably work better because these measures would be directed more to lower-income households.

The best way to boost the economy right now would be to increase federal aid to the states, which are facing their worst financial crisis in decades.

Unlike the federal government, which is able to run a deficit, the states must balance their budgets. During a recession, revenue falls and spending needs rise, so states raise taxes or cut spending. This helps restore their budgets but provides a negative stimulus to the overall economy. This year it has cost in the range of $40 billion to $50 billion, with higher costs expected in 2003. And because the states are cutting spending on education, health and infrastructure, the long-term ramifications will be negative. Several states are cutting their prison budgets by releasing inmates early.

An administration that purports to care about economic growth and “leaving no child behind” should help states maintain critically needed spending on education and other investments. This would boost the economy now and augur well for the future.