Temporary Incentives Will Offer More Bang for the Buck

Peter R. Orszag and
Peter R. Orszag Vice Chairman of Investment Banking, Managing Director, and Global Co-Head of Healthcare - Lazard
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

November 19, 2001

In the wake of the terrorist attacks of Sept. 11, Congress and the Bush administration are debating the best way to stimulate the economy through spending and tax changes. The leaders of the House and Senate Budget committees have emphasized that any stimulus package should contain only temporary items. We agree; limiting the stimulus package to temporary changes makes good sense and offers several key benefits.

First, the nature of the problem at hand is that the economy is experiencing a temporary slowdown and needs to return to its long-term course. The right policy response would focus on getting the economy back on its long-term path as soon as possible.

Second, while long-term economic prospects are good, the long-term budget situation has
deteriorated dramatically. In May, for example, the non-Social Security budget had a projected 10-year surplus of $3.1 trillion. Since then, that projected surplus has fallen by 97 percent. To be clear, the nation can afford a stimulus package. What it cannot afford is to waste funds on long-term tax cuts that do nothing to stimulate the economy now.

The economic and budget outlooks suggest that any stimulus package should maximize its “bang for the buck.” That is, the package should focus on generating the most near-term effects, since the whole point of the stimulus is to boost a sputtering economy now. The package should minimize any long-term revenue loss to avoid hurting the budget situation any further and to minimize any increase in interest rates. Smaller surpluses or larger deficits would raise long-term interest rates, which would partially offset the positive effects of a stimulus package by discouraging business investment and housing sales.

Even apart from their smaller impact on interest rates, temporary incentives can generate bigger short-term investment responses than permanent ones. For example, temporary investment incentives lead firms to substitute investment into the period in which it enjoys a larger tax benefit—which does not happen with a permanent investment incentive. Why make something permanent when it actually would work better and cost less if it were temporary?

Despite the benefits of limiting a stimulus package to temporary items, the proposals put forward by the Bush administration and the House Ways and Means Committee include several permanent or long-lasting tax changes. For example, the proposals include permanently reducing the capital-gains tax rate and eliminating the corporate alternative minimum tax (AMT). These proposals would be ineffective as stimulus programs.

Whatever its merits in other contexts, a capital-gains tax cut has several crucial drawbacks as a stimulus tool. First, proponents of a capital-gains tax reduction typically argue that it would stimulate national saving, not consumption. But that’s exactly what we don’t need in the short run: An effective stimulus needs to boost consumption, not saving. Second, a capital-gains tax cut is typically promoted as producing economic benefits in the long run, not the short run. Even those who believe that a capital-gains tax cut would encourage business investment acknowledge that
the impact is slow. Third, a capital-gains tax reduction is not an efficient way to target new investment because the tax cut would apply to capital gains on existing assets, and those gains are a return to prior investment.

Permanent repeal of the corporate AMT is another poor stimulus measure. The corporate AMT applies when corporations owe no regular income tax because of substantial deductions or other tax preferences relative to their income. Unlike investment incentives, which only give tax breaks to firms that are undertaking new investment, eliminating the corporate AMT would give tax cuts to firms regardless of whether they are investing at all.

Furthermore, even supporters of eliminating the AMT have shown that any beneficial impact would be tiny in the short run. The implication is that, regardless of whether it would be warranted as part of a broader tax reform, elimination of the corporate AMT is an extremely blunt and inefficient approach to encouraging new investment in the short run. It also would cost $24 billion during the next decade.

If policymakers want to use tax policy to stimulate the economy in the short run, two approaches would maximize the bang for the buck: temporary investment incentives and a rebate for low- and moderate-income workers.

Temporary investment incentives make sense as a stimulus policy: They encourage investment when it is most needed. But if they are designed poorly, they will be useless at best and counterproductive at worst. Here’s how to design them right. First, Congress should announce that any incentive that eventually becomes law will be retroactive to Sept. 11. This will remove the incentive for firms to wait to find out the effective starting date for any incentive and it will ensure that the subsidy operates when the economy needs it most—now.

Second, the subsidy should expire at the end of 2002. This will give firms incentives to invest now or next year rather than waiting. It makes more sense to encourage investment in 2002 than in 2003 or 2004, when the economy probably will be fully recovered.

Third, Congress should introduce a sliding scale by making the incentive bigger the sooner the investment is made. For example, lawmakers could allow a 50 percent write-off for investments made by the end of 2001, 40 percent for investments made in the first quarter of 2002 and so on down to a 10 percent immediate write-off for investment made in the fourth quarter of 2002. This sliding scale would encourage investment now, maximize the chances that Congress would actually let the temporary tax provisions expire and avoid a dramatic drop-off in investment after they do.

The other tax proposal that makes sense is a temporary household rebate targeted to lower- and middle-income households. Roughly 34 million tax filers received no rebate under the first round of rebates sent out this summer, and another 17 million received only a partial rebate. Recent research suggests that these households have tendencies to spend a greater proportion of any new income than high-income households do—and the more the rebate is spent, the more effective it is as a stimulus.

A stimulus plan also should include spending expansions. For example, the unemployment-insurance system is an important “automatic stabilizer” that mitigates the severity of any economic downturn. Unfortunately, the unemployment-insurance system is not well prepared for the current economic slowdown. The eligibility rules are outdated, some states did not accumulate sufficient trust funds during the recent economic boom and benefit levels are relatively low.

Temporary, federally financed expansions in the unemployment-insurance program would represent an effective stimulus; most of any additional benefits provided would likely be spent. Unemployment insurance is particularly well-targeted to maximizing its bang for the buck since it is available only to unemployed workers (who have experienced a reduction in income from the loss of their jobs and whose consumption expectations may therefore exceed their current income). Other assistance programs for those most adversely affected by the recession also could be expanded.

The stimulus package also should ease the burden on state budgets. The economic slowdown has caused many states to enact or plan across-the-board spending cuts, while others were forced to raise taxes in their fiscal 2002 budgets. These changes—which are necessitated by balanced-budget rules in almost all states—are counterproductive in terms of stimulating the economy.

To avoid restrictive fiscal policies at the state level in the middle of an economic downturn, the federal government should provide temporary fiscal assistance to the states. One mechanism for doing so would be a revenue-sharing program, such as existed in the 1970s and 1980s. Such an
approach may take time to design and implement, however. A more timely alternative would temporarily increase the federal matching rate for the federal-state Medicaid program. An increased federal match would partially enable states to use less of their own funds for Medicaid, which would help to avoid counterproductive tax increases or reductions in other state programs.

Finally, policymakers should offset the cost of any short-term stimulus package and the long-term continuing costs of any permanent additional antiterrorism measures by scaling back part of the already legislated future tax cuts for those least in financial need of additional tax reductions. Whatever one’s view of the affordability of the tax package enacted last spring, it was passed before the nation realized it would need to finance a new war. Furthermore, combining short-term stimulus with long-term fiscal discipline provides more stimulative impetus to the economy than a stimulus package alone since it restrains any increase in interest rates that could undermine the effectiveness of the stimulus.

As a first step to restoring long-term fiscal discipline, policymakers should freeze the top marginal tax rate, rather than allowing it to decline in the future as scheduled under current law. Doing this could finance the short-term stimulus package proposed previously without endangering long-term fiscal discipline.

Such a freeze would raise surpluses by more than $100 billion between 2002 and 2011. It would not represent a change relative to current law until 2004, well after the nation’s short-term economic challenges are likely to have passed. It would affect only 1.1 million taxpayers who have an average annual income in excess of $1 million. Even those high-income taxpayers would only forgo a future marginal tax cut rather than experience a tax increase relative to today’s rates, and they still would enjoy a continuing reduction in average tax rates (since the tax rates applying at lower levels of income would continue to decline).

This package—temporary incentives for business investment, a rebate for lower- and moderate-income households, some temporary spending expansions and assistance to states, and a freeze on the scheduled tax cuts for the highest-income taxpayers—would be much more cost-effective than the alternatives being proposed. It would maximize its stimulus to the economy
in the short run, when stimulus is needed, while ensuring that we have the resources to meet our longer-run needs.

A stimulus proposal that includes permanent tax cuts would have the opposite effect: It would provide only limited stimulus to the economy in the short run and endanger the nation’s long-term ability to finance its Social Security, Medicare and defense obligations.