Short-Term Stimulus, Long-Term Growth and JGTRRA

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

June 9, 2003

Mr Chairman:

Thank you for inviting me to testify at this hearing on the effects of the Job and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) on jobs and growth. My testimony is divided into a summary of the major conclusions and the analysis supporting those conclusions. My principal conclusions are as follows:

Taxes and short-term stimulus: In the short run, in an economy operating with excess capacity, increases in aggregate demand can raise output and income even without raising the capital stock.

JGTRRA and short-term stimulus: JGTRRA will boost aggregate demand in the short term and thereby generate higher short-term levels of income and employment than would occur if no policy were enacted. But this is a very minor accomplishment. Almost any increase in spending or cut in taxes would boost a sluggish economy. JGTRRA was not the only policy option: policy makers could have provided more progressive tax cuts, increased federal spending or transfers to the states, and extension of unemployment benefits. In comparison to those other policies, JGTRRA is a poor way to stimulate the economy in the short-term: the same or bigger stimulus could be obtained with a lower long-term cost, simpler rules, a more equitable distribution of benefits, and less deterioration (or stronger preservation) of basic social needs. The two principal components of the plans—acceleration of the 2001 tax cuts and dividend/capital gains tax cuts—are regressive. This implies that they will be less effective in stimulating current activity, holding the size of the tax cut constant, than more progressive options, since high-income households are less likely to spend available resources immediately than would low- or moderate-income households.

Taxes and long-term growth: In the long run, economic growth reflects expansions in the capacity to produce goods and services. Such expansions, in turn, reflect increases in labor supply and capital, improvements in the allocation of labor and capital, and technological advances. Tax cuts can increase growth by providing incentives to raise the level, and improve the allocation of, labor supply, saving, and investment. But tax cuts can reduce long-term growth by raising after-tax income (which discourages work), by providing windfall gains (which encourages consumption rather than saving), and by reducing public and national saving (which reduces the capital stock owned by Americans and hence reduces future national income). The net effect on growth depends on the balance between these various impacts.

JGTRRA and long-term growth: Although the tax cut is called a “Jobs and Growth” package, this moniker is extraordinarily misleading. The Joint Committee on Taxation has analyzed the tax cut passed by the House of Representatives (which is essentially JGTRRA with the sunsets removed). This analysis explicitly incorporates macroeconomic feedbacks, as tax cut advocates have demanded for years. Using a variety of models and assumptions, the JCT shows that the House plan would reduce the size of the economy in the second half of the decade, and by implication would reduce the size of the economy by increasing amounts after that. The reason why JGTRRA, extended, would reduce growth is that the impact of the tax cuts in raising individuals’ after-tax income holding work constant, the increase in the stock market, and the increase in the deficit, will reduce net work, raise consumption, and reduce national saving. In the long-term, all of those effects reduce the size of the economy. In the case of JGTRRA, those effects outweigh the positive impacts on incentives to work and save. The acceleration of EGTTRA would reduce marginal tax rates for fewer than one-third of all tax-filing units and so is unlikely to have substantial supply-side benefits. Despite claims suggesting sizeable benefits for small business, only about one-third of small business returns would receive marginal tax rate cuts and only 2 percent of all small business returns would benefit from the reduction in the top tax rate. The cuts in dividend and capital gains tax rates will do little to improve the allocation of capital.