All Tax Cuts Are Not Created Equal

It is now virtually certain that lawmakers will pass a tax cut this year. President Bush and congressional Republicans have campaigned unceasingly on this goal. Democratic leaders have recently endorsed cuts. And last week’s testimony by Federal Reserve Chairman Alan Greenspan in favor of tax cuts has sealed the deal. Greenspan is widely and appropriately respected for his economic views, and his opposition to such cuts in the past few years has been an important constraint on the political process.

However, agreement on tax cuts is just the beginning of the story. While the case for tax cuts is certainly stronger now than it has been in the past, the case for the president’s tax plan is weak. The real debate will be about what kind of tax cuts we have.

The president’s plan is huge, back-loaded and tilted dramatically toward the highest-income households. Bush’s proposal would cut revenues directly by $1.6 trillion between 2002 and 2011. And if we fix the problems that his plan would create with the alternative minimum tax, there would be another $200 billion in revenue cuts. Including the extra interest payments on public debt that would not be paid off because of the tax cuts, the total 10-year tab comes to $2.1 trillion.

The proposal’s effect also is significantly delayed; there is no tax relief planned for 2001 and just $21 billion (about $75 per person) in 2002. And, when the plan fully phases in, households in the top 5% of the income distribution would receive half of all of the benefits.

What problem is the president’s tax plan supposed to solve? His proposal seems best designed to fight a hypothetical recession among high-income households that might occur in 2011. Most citizens are likely to agree that is a poor way to squander our hard-earned surpluses.

The president’s plan is poorly designed to fight a recession that might occur now, even though that is how the president and his advisors often package the proposal. An anti-recession package should be small enough not to spook financial markets or to raise long-term interest rates. It should be immediate; we don’t need to cut taxes in 2010 to fight off a downturn in 2001. And it should be focused on low- and middle-income households. These are the people who are most likely to lose their jobs in a recession, and the ones for whom tax cuts would give the biggest bang for the buck in stimulating the economy. Bush has suggested implementing his tax cut sooner to help fight a recession, but that would raise the long-term costs and the impact on interest rates, and would not mitigate the distributional effects.

The president’s proposal doesn’t make taxes fairer. High-income groups have had by far the largest growth in after-tax income and in wealth over the past 20 years. And if the purpose is to reduce taxes on overburdened American families, it should be noted that for the vast majority of households, taxes are currently lower or as low as they have been in the last 20 or 30 years. Nor does the proposal do much to take down the “toll booth to the middle class” that Bush has criticized. Many alternative proposals—to make the child credit refundable, expand the earned income credit or provide credits against payroll taxes—would do much more.

Since the cost of the proposed cut would be almost as large as the entire budget surplus other than Social Security and Medicare, it may be that the goal is to restrict the size of government. But Bush and congressional leaders on both sides have advocated new programs for education, prescription drugs and defense. If the tax plan were passed, either these options would have to be eliminated or funds would have to be taken from Medicare and Social Security, which Congress has pledged not to do. Nor is it obvious that tax cuts effectively shrink the government. Public spending rose, for example, after the 1981 tax cuts.

All these issues point to the desirability of a tax plan that is moderately sized, implemented quickly and focused more evenly on lower- and middle-income households. A plan with these features would be more effective in stimulating the economy in the short run, providing fairer taxes in the longer run, maintaining fiscal discipline and leaving some money for other policy priorities.