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The Tax Cut

William G. Gale

Though considerably smaller than the president’s proposed $726 billion economic package, President Bush is poised to sign the $350 billion tax cut plan passed by Congress. While the White House is hailing the tax cut as a victory, many Democrats see the cuts as fiscally irresponsible.

What will the tax cut plan mean for you? What are the nuances of the new law? Will the cuts help or hurt the economy?

William Gale, senior fellow of economic studies at the Brookings Institution, was online to discuss the ins and outs of recent tax cut package.

The transcript follows.

William Gale: Thanks to everyone in advance for posting questions. It looks like there are alot of interesting issues to discuss and I’ll try to get to as many as possible.

Boston, Mass.: Mr. Gale, in the early 90s I made it a point to ask my economics professors if the Laffer curve made famous by the Reagan tax cut was born out by the empirical evidence. I was told that it was not, that lowering the tax rate in this instance did not result in increased revenues. Is this correct and what medium term (3-5 years) revenue impact should we rationally expect from the current Bush cut given the data we have?

William Gale: The Laffer curve is a clever idea, but it does not often apply in practice. The basic idea is that if you tax something at zero percent (that is, you don’t tax it) you end up with no revenue. Likewise, if you tax something at 100 percent, you end up with no revenue (since if 100 percent of wages were taxed, for example, no one would work!). Therefore, the argument goes, there must be some tax rate between 0 and 100 percent that maximizes revenues. If current tax rates are higher than that tax rate, then cutting tax rates can indeed raise revenues.


Anyway, as I said, it is a nice idea, and although tax policy has many problems, having tax rates above the revenue-maximizing rate is NOT one of them. As a result, the tax cuts just passed will reduce revenue—virtually everyone agrees to that now. Members of the Administration (incl the Treasury Secretary) have been saying that tax cuts (a) will increase economic growth and (b) will increase growth so much that it will raise revenues. The first part (a) is questionable—most estimates suggest that the long-term effect of the tax cut on growth will be zero or worse. But the second part (b) is undoubtedly wrong. Even if the tax cut moderately raises growth, it won’t do so anywhere near enough to “pay for itself.” Studies by the Joint Committee on Taxation and Congressional Budget Office confirm this fact.

Washington, D.C.: How will perception of the “temporariness” of the provisions affect investment and spending decisions? Will the current fact that certain provisions will sunset impede business investment, or will investors front-load investments to take advantage of tax cut benefits before they expire? Same with individual consumers. Or, will people just assume that all the cuts will be made permanent and then proceed accordingly?


William Gale: That is the $2 trillion question. That is, if we extended all of the sunsets that are now in the tax code, it would reduce revenues by about $2 trillion over the next 10 years. In the long-term it would reduce revenues by 2.4 percent of GDP—to put that in perspective, that is 3 times the size of the 75-year deficit in social security!! So what happens to the “sunsets” (the expiration of the tax cuts) is going to be a crucial question going forward.

As to what people think, I don’t know. The conventional wisdom is that temporary provisions have always gotten extensions and these will, too. But I think these might be different—they are so big, and so expensive, that Congress might blush at passing them. Especially if the old budget rules get reinstated—the so-called PAYGO rules which required that tax cuts be paid for with spending cuts—it becomes less likely that the sunsets will be removed. (This is distinctly a minority opinion though—Democrats fear the sunsets will be removed and Republicans promise they will be removed.)

How all this affects people’s behavior is hard to tell because it is not clear what people should think. I would guess that the temporariness would make businesses a little more wary about assuming the benefits will be around forever, but I don’t think it will have much effect on households, because it does not seem like households do alot of planning ahead in this regard.

Toronto, Ontario: Am I correct that the final signed version of the bill keeps in place the foreign earned income exemption?

William Gale: yes

Ashland, Mo.: Many people complain that the tax bill favors the rich. This is always true if the income tax is reduced. Would a better measure be how the effective tax rates are changed for various income groups? For example, didn’t the income tax become more progressive (as measured by effective tax rates) after Reagan’s tax cuts?

William Gale: This is another tricky question. By any reasonable measure—emphasize reasonable—the tax cut is regressive and it makes the tax system more regressive.

The popular debate tends to emphasize the dollar amounts, but a better way to look at it is to look at the percentage change in after-tax income. A tax cut that increases everyone’s after-tax income by the same PERCENTAGE (not the same dollars) keeps the after-tax income distribution the same. By this measure (and as noted by all other measures), the tax cut is very regressive, giving increases in after-tax income of several percentage points to the highest income households and virtually nothing to the bottom 40-50 percent.

Also, it is not appropriate to look just at INCOME taxes. The Administration could have proposed to cut any tax, but it chose a progressive tax to cut. We have a tax SYSTEM and any time you reduce one of the most progressive taxes, you make the overall system less progressive.

This can get confusing.I recommend people check out the distributional tables and explanations at click on commentary and estimates and then on distributional and revenue estimates and you will find lots of information and explanation of these issues.

Oxford, UK: There’s a lot of worry here that the tax cut just passed, combined with the weakening of the dollar, will lead to a further chill in the global economic situation. People seem to think that the tax cut will actually weaken demand as the U.S. government soaks up capital to finance the debt, while at the same time Americans find it less advantageous to import due to the weak dollar. What do you think of this?

William Gale: The tax cut should raise aggregate demand in the short-term in the US, and should attract capital from the rest of the world.

The weakening of the dollar increases our exports, reduces our imports and thus further reduces production in the rest of the world.

So in that sense this is not a good tax cut for the rest of the world. On the other hand, if a global recovery is to be US led, this MAY jump start the US economy.

Kansas City, Mo.: Warren Buffett has been critical of the tax cut plan but I heard one person say it motivated by self interest in that the change in taxation of dividends will make his business model less advantageous. I’m not sure I understand enough about how taxes and dividends are handled for individuals compared to companies. Is there anything to this?

William Gale: I have no idea how the tax change will affect Warren Buffett’s business interests, but I think the view that he is just motivated by his business interests is profoundly wrong. Buffett has been outspoken, principled, and eloquent in his views that there is such a thing as a just society and making taxes more regressive may not be a good thing. He also was one of the main people involved with Bill Gates Sr. in opposing repeal of the estate tax, and that clearly has nothing to do with his business interests.

The people whose motives should be under question should be the Administration. They have tried to justify this tax cut in every conceivable way (long-term growth, short-term stimulus, help small business, help the elderly, help soldiers in Iraq) and their statements are increasingly hollow. None of the justifications work very well and all of them leave out the costs of the tax cut.

Washington, D.C.:Was anything done about the impending Alternative Minimum Tax problems?

William Gale: Yes and no. The exemption in the AMT was raised by $9,000 for married couples filing jointly and smaller amounts for other filers. But the key point is that this is only through 2004, at which point the increase expires (and the increase in the AMT exemption that was legislated in 2001 also expires—that was another $4,000). So under current law, the AMT exemption for couples filing jointly falls from $58,000 in 2004, to $45,000 in 2005. As a result, the projected number of AMT filers rises from about 3.6 million in 2004 to 13 million in 2005.

The Administration and the Congress need to address this problem—and the sooner the better. I had been saying all winter and spring that if they were going to do anything on the tax side, it should be to fix the AMT. Oh well.

Lincoln, Maine: What determines how much you get for a refund?

William Gale: The refund, as I understand it, is based solely on the increase in the child credit—and so would be up to $400 per child dependent, based on last year’s tax return.

Atlanta, Ga.: How much concern are you hearing (if any) from Republican senators who voted in favor of the tax cut? Is there overwhelming support for the tax cut or was it more loyalty?

William Gale: I have heard from people who are VERY well connected that half of the Republicans in the Senate thought the bill was basically an ideologically motivated bad joke and they essentially held their nose and voted for it because the President of their party wanted it. But, like all gossip, this should be discounted somewhat. You can hear almost anything around town if you listen long enough.

Having said that, my strong sense is that this was not strongly supported. If you had asked Senators a year ago to list the five tax changes they would have most wanted, I would guess that none of them would have listed dividend tax cuts.

New York, N.Y.: Have we finally done away with the silly Robert Rubin idea that budget deficits affect long term interest rates? I mean, in the ’80s deficits soared but interest rates fell, in the ’90s deficits decreased and interest rates fell, and in the ’00s we’re back to large deficits and interest rates are STILL low. After all, the government’s borrowing to support the deficit is only a tiny fraction of all borrowing, so how much effect could it have? Rubin had a nice theory, but it doesn’t seem to be borne out in the real world. What do you think?

William Gale: Great question. The short answer is that deficits matter. The longer answer takes a little awhile:

When a government spends more than it collects in revenues, it has to borrow to make up the difference (or print money, but skip that). Borrowing is negative saving. Therefore, if private saving does not change, or if it rises by less than 100 percent of the decline in public saving, then national saving (sum of public and private) falls. Almost all of the evidence suggests that national saving DOES fall when government borrowing rises.

Now, why does that matter? Well, the same reason it matters for a family. A family that saves less now will have less future income from its assets. Likewise, a family that borrows more now (same thing as saving less) will have higher debts to repay in the future. Either way, by borrowing more and saving less now, the family reduces its future income. Same thing is true for the country. If national saving falls, then future national income HAS TO FALL.

Ah, but what about international capital flows? Can’t we just borrow from the rest of the world? Well, yes, BUT in doing so, we create a new debt to repay and that ends up reducing our future income. Put differently, when our national saving drops, borrowing from other countries will let us keep up DOMESTIC PRODUCTION, but we will have a smaller claim on that production and therefore we will have lower NATIONAL INCOME. (for techies, this is the difference between GDP and GNP.)

So Rubin is right—deficits matter. They reduce future national income. This can have a big effect. The decline in fiscal outlook since January 2001 implies that future national income will be lower by about $800 per person by 2012. For details on that, see a paper by Peter Orszag and me on the Brookings web site.

Now, what about deficits and interest rates. Well, it is a little bit of a red herring. Everything noted above about deficits reduce future national income applies REGARDLESS OF WHETHER INTEREST CHANGE OR NOT.

But the evidence suggests that (a) controlling for other factors, like inflation, monetary policy, state of the economy, etc. and (b) looking at anticipated future deficits, there is an impact of deficits on interest rates. The examples given by the questioner do not control for any of the other factors and so are not good evidence against the view that deficits affect interest rates. All they show is that lots of other things ALSO affect interest rates. That’s fine. No one ever said that deficits are the ONLY thing that affects interest rates.

Again, to emphasize, it makes no sense to look at correlations between ONLY interest rates and deficits not controlling for anything else. If we wanted to play that game, one could look at the decline in investment over the last few years and the decline in interest rates and erroneously conclude that investment does not depend on interest rates.

So, bottom line, is that I think Rubin is right to be concerned about deficits. He may have emphasized the interest rate channel more than I would. I would emphasize the impact of deficits on national saving and the required reduction in future national income, both because it is more certain and because it is more important. But even Greg Mankiw, a superb economist who is the head of the President’s Council of Economic Advisers has written that deficits matter significantly for interest rates. Using Mankiw’s estimates, the decline in fiscal status over the last two years has raised long-term rates by over 100 basis points RELATIVE TO SHORT-TERM RATES. So why are long-term rates so low right now? In part because short-term rates are low, in part because expected inflation is low (and possibly negative—deflation), and in part because business are not investing so there is little demand.

Long answer to a simple question, but it is a key issue looking forward.

Gaithersburg, Md.: Does the tax cut affect the ‘marriage penalty?’

William Gale: There are modest adjustments to move marriage penalties for some middle and upper income households, but (a) they are temporary, (b) they increase marriage bonuses as well as reduce marriage penalties and hence are not well designed and (c) they ignore the future reduction in marrige penalties for low income households that were legislated in 2001.

Bethesda, Md.:
Mr. Gale,

Is it basically true that the top half of wager earners in America pay 96.09 percent of the total taxes as a dollar amount. If not how much do the top half pay as a a percent of the total dollar amount? Thanks.

William Gale: No. The literature on the distribution of taxes is often muddled. I do not have the exact figures on the distribution of the tax system, but (a) the right figures are posted on the web site and (b) I think the figures in the question may refer to one particular tax. The overall system is much less tilted toward high-income households than the data in the question suggest.

Modesto, Calif.: Doesn’t the Laffer Curve simply stand for the uncontroverted (and uncontrovertible) idea that there are diminishing marginal returns of taxation? That’s not just a clever idea. It’s an economic axiom.

Also, isn’t it true that tax revenues remained stable in real terms throughout the 1980s notwithstanding the Reagan tax cuts, but that government spending exploded?

William Gale: No the Laffer curve does not just stand for the view that there are diminishing marginal returns. The Laffer curve is taken universally to refer to the notion that if you cut tax rates, you can in certain circumstances raise revenues. As noted earlier it is correct as a theoretical proposition that is carefully stated to note that “under certain circumstances.” All of the evidence that we have shows quite firmly that it does not apply to things like the acceleration of the 2001 tax cut that was just enacted.

Washington, D.C.: Mr. Gale:

Earlier you said tax cuts will have no impact on growth or will negatively affect growth. Are you suggesting they will have no stimulative effect? Also, isn’t there some trade off between aggregate taxation and economic efficiency?

William Gale: Good question—I wrote too quickly. Tax cuts can have two sets of effects on economic growth.

First, changes in tax rates affect private activity. They change the amount that people work, save, invest, etc. Note that they can change those things in either direction—by raising the return to, say, working, the tax cut would encourage work. But by raising after-tax income at the person’s already existing level of work, the tax cut would induce people to work LESS. The net effect is ambiguous. Similar statements apply to saving. For example, a dividend tax cut that boosts the stock market will raise wealth, raise consumption, and therefore will REDUCE saving. But for now let’s assume that the net effect of these changes in private sector activity is positive. That is, these changes serve to increase future national income.

The second effect of tax cuts is that they reduce the deficit and therefore reduce national saving and reduce future national income (see earlier answer).

Thus, the NET effect of the tax cut is the sum of the two effects above. The problem is that the second is bigger than tax cut advocates like to let on (again, see above).

Estimates of the 2001 tax cut and the 2003 tax cut suggest that the negative impact of tax cuts on national saving (via the deficit) are as big or bigger than the net positive effects from the change in economic incentives (the first effect).

Cape Town, South Africa: To what extent are columnists such as Paul Krugman exaggerating the “fiscal crisis” that could result from the tax cut, as well as the claim that ‘radicals’ have hijacked domestic fiscal planning in an attempt to cut social spending programs that otherwise would be politically untouchable?

William Gale: I think Krugman has been not only right on the money but even prescient in his analysis.

Falls Church, Va.: Hi Bill, big fan of your work.

In your opinion, out of all the tax breaks contained in this legislation, which tax break is most unworthy of being included in a bill that is supposed to provide “jobs and growth?”

William Gale: That’s a fun question. Most of the worst individual items got cut out in negotiations. But I think the worst part for growth is the overall fact that the tax cut not only raises deficits, but does so via all of the sunsets. The “official” cost of the bill is $350 billion, but if all of the tax cuts are extended, the net cost will be almost $1.1 trillion, or more than 3 times as much. For reasons noted above, the increase in the deficit will create a long, slow drag on economic growth.

Washington, D.C.: I believe the tax reduction on dividends will cause increased competition for muncipal bonds. States will need to pay more interest on bonds to stay competitive during a time they are having severe budget troubles.

Do you agree with my assessment of a shift in cost to the states? Why has there been no discussion of the financial impact on states, which will ultimately come back on individuals?

William Gale: I agree. The states are being hit from all sides. They have to cut spending and raise taxes to meet balanced budget rules. The 2001 tax cut and the 2002 tax cut and the 2003 tax cut will reduce their revenues further, unless they decouple their income taxes from the federal income tax. And the increased competition from dividend paying stocks will hurt them, too. Remember, the way that the tax policy is SUPPOSED to work, if it is effective, is to take capital away from the state and local sector, the housing sector and the small business sector, and funnel it to the corporate sector. So all non-corporate sectors are going to get hit by the reallocation of capital. That should improve the overall efficiency of the economy, but hurt those sectors.

The bill does provide $20 billion in relief for the states over 2 years, but in my view that is too little and the states and the economy would have been much better off if more had gone to the states and less to high income households.

Columbia, Md.: From the huge tax cut of 2001 there has been no visible growth in revenues or jump-starting of the economy, so how can the administration and half the Senate claim this much smaller cut will do what this larger cut did not?

William Gale: They do not appear to feel constrained by fact or logic, when it comes to tax policy.

I agree that the short-term impact of the 2001 tax cut appears to have been small. The current tax cut will also put money into the economy now, but not in a very stimulative way. By giving such a large share of the funds to high income households, who are not living paycheck to paycheck—to say the least, the designers ensured that only a small share of the tax cut would be spent soon. A much better idea would be to transfer the funds to state and local governments, who would otherwise have to cut spending or raise taxes, both of which hurt the economy in short-run. David Broder’s column in today’s Post (a little free advertising!) also makes the point that state and local government is what people see on a day to day basis, and when it is shutting down or cutting back (e.g. closing school early) it does not bode well for people’s confidence.

Springfield, Va.: On the double taxation of dividends, hasn’t the relief been given to the wrong sector. That is, for maximum beneficial economic impact, should not the relief be given at the corporate level in order to equalize the treatment of interest and dividends for tax purposes?

William Gale: That is a tricky question. The Administration’s proposal gave the relief at the individual level, but only if the dividend was paid out of after-tax income. That actually linked up payment of corporate taxes with non payment at the indivdual level. The House and Senate bagged that approach and just gave cuts to all dividends, which is what the final bill does.

Here is the problem in trying to solve the so-called double taxation problem. Only about one quarter of dividends are double taxed. About one quarter are never taxed, and the remaining half are taxed once, either at the firm level or the individual level. A good system would tax ALL corporate income ONCE. But under our system, if you just allow deductions for dividends at the
corporate level, then you have done nothing to reduce tax sheltering at the corporate level. I would rather see them solve both problems (the non-taxation of some corporate income and the double taxation of other corporate income) at the same time.

Arlington, Va.: Why doesn’t the government ever increase the amount of investment losses one can deduct? Having it stuck at $3,000 for the last twenty years seems a bit ridiculous in light of the recent bear market.

William Gale: Good question. The treatment of capital gains contains several mitigating factors and I think is best thought of as an effort to maintain rough justice (which I don’t think is actually maintained, but that is another story). Capital gains are not taxed unless they are realized, not taxed at all under the income tax if held until death and when they are taxed, they are taxed are preferred rates. All of this reduces the taxation of capital GAINS dramatically, relative to other asset income.

Capital LOSSES are fully deductible against capital gains until net capital gains are zero. Then another $3,000 can be deducted against OTHER INCOME, which is taxed at the full income tax rate. Thus, the tax benefit for net capital losses up to $3,000 is more than twice as big as the tax on capital gains.

Whether $3,000 is exactly the right number is hard to say—certainly, there are no first principles to apply here. But allowing unlimited losses would promote sheltering activity that would drain revenue mercilessly.

Alexandria, Va.: I, frankly, am glad that there will be tax cuts that will benefit my personal finances in coming months and years. I am financially comfortable and much of my uneasiness will be lifted by this action.

I expect to retire debt with everything that I will either receive back or anything that the tax man would have collected. There will be no additional spending.

I have been arguing with friends that the fact that I’m paying down my debt rather than spending it actually will stimulate the economy and create jobs because my actions will free up capital in the market for other people to use at lower rates. They can take the money that I’m no longer borrowing (hopefully at lower interest rates than what I had been paying — which wasn’t all that high in comparison to the Carter years) and invest in creating jobs and business expansion.

Am I being too optimistic? Will my paying down my personal debt actually support expansion of our economy? I hope so! I don’t like this gray cloud of debt hanging over my retirement.

Thanks for your thoughts.

William Gale: First thing to note is that if what you need to do is pay off debt, you should do so without regard to how it affects the economy. We have an extraordinarily large economy and a typical person’s actions have no effect on the outcome.

Having said that, there are two ways to make the economy grow in the short-run. One is to get businesses to USE more of their EXISTING capacity, the other is to get them to build MORE capacity. Right now, businesses are using a low proportion of their existing capacity relative to historical norms. That, to me, implies that it is unlikely that they will want to invest alot right now—if they are not using their existing capacity, why would they want to build more capacity. Therefore, it seems most likely that in the short run, expansion of the economy will come from getting business to use more of their existing capacity. That will only happen if people spend more.

Bethesda, Md.: As a moderate Democrat, I guess I just don’t get what seems to be a fundamental tenet of Republican tax policy: that unearned income should be taxed at a lower rate than earned income (or, perhaps, not taxed at all). That concept does not seem to jibe at all with another mantra of theirs: “support for working families” (a line which both parties use). Doesn’t it make sense that most people would see more incentive to work harder if their earned income was taxed less than other income? And why is it good policy to more lightly tax income gained from investing rather than working? Thanks in advance for helping me understand this apparent contradiction.

William Gale: This is a long-standing debate about the right direction for tax policy. Your note that the efforts to reduce capital taxation may contradict their rhetoric on working families is well-taken.

The debate about consumption versus income taxes, or capital versus labor taxes, is too broad to get into here. Republicans largely support consumption taxes and doing away with capital income taxes on the grounds that this will spur growth. Others, myself included, argue that the growth effects are likely to be small or vanishing once we look at the system that would actually be implemented by Congress rather than the system that exists on paper, that the new taxes will not be as simple
as claimed, and that they will be highly regressive and therefore that the supposed benefits are smaller than claimed and the costs are bigger than advocates claim. I can refer you to a book called “Economic Effects of Fundamental Tax Reform” that i edited in 1996, with Henry Aaron at Brookings.

Bernadsville, N.J.: Why do you think President Bush pushed so hard for a reduction in taxes on dividends, when almost all economists argue that its short-run impact is minimal? From a political perspective, wouldn’t it have made much more sense to push for a package that would stimulate the economy in the run-up to the election?

William Gale: I think the President wants to move to a tax system that raises significantly less revenue, taxes capital income less than we do now, and sharply reduces taxes on high-income households and businesses. The dividend tax cut idea fits in with all of those goals.

The problem of course is that those goals may not be the best for society to pursue, especially if one believes, as I do, that such a strategy would generate little or no growht, would unfairly shift the burden of government to those less or least able to pay, and would force either reductions in needed government services or fiscal calamity.

Fort Smith, Ark.: How do I know if my family will recieve a check?

William Gale: I believe the refunds are based on whether you have children or not. Best way to check would be to look at

Southern Maryland: While I have concerns about the size of the tax cut, I believe the real problem is the complexity of the tax code. With all the exemptions built into the code, how can anyone accurately predict who will truly benefit from the tax cut?

Over the years, I’ve warmed up to Steve Forbes’s idea of a flat tax. I would suggest including two deductions—the personal exemption and home mortgage interest.

William Gale: The problem with Forbes flat tax from the perspective of simplicity is that you would like the personal exemption and the mortgage interest deduction; others would like to keep some combination of charitable deduction,health insurance deduction, state and local tax deduction, earned income credit, firm’s deduction for payroll taxes and so on. Pretty soon, with everyone adding back in their “favorite” deduction, the system would end up complex again. Also, rates would be high because all of the deductions reduce the amount of taxable income.

Finally, note that in Forbes flat tax, the one thing one should NOT have is a mortgage interest deduction. Why? Because the flat tax does not tax interest INCOME, so should not give a deduction for interest PAYMENTS. The more general point here is that the tax SYSTEM needs to fit together well.

Laramie, Wyo.: Dr. Gale,

Thanks for being on-line today. I have many questions; hopefully not too many:

How well do economists understand the effects of tax cuts? Can one quantify the effects and give some sort of confidence bounds, that most economists predictions would fall within? Does the political debate mirror these predictions, or is it skewed by dogma?

Finally, where can a member of the public go to find unbiased economic predictions (hopefully with the aforementioned confidence bounds)?

William Gale: The effects of tax cuts can be divided into their direct impact on the private sector and their impact on the deficit (see above).

As for the best analyses, the Joint tax committee and the congressional budget office both have done macroeconomic analysis of recent tax proposals in an unbiased and professional way.

Harrisburg, Pa.: What do the economic models say the impact of the tax cut will be? Which sectors benefit the most, and are these sectors with high savings rate or high spending rates? Was this the most efficient way to stimulate economic growth?

William Gale: This tax cut certainly is not the most productive way to stimulate growth for the simple reason that IT DOES NOT STIMULATE GROWTH in the long-term and won’t even if it is extended. Analysis by the Joint tax Committee, by the Congressional Budget Office, by reputable macro consulting firms like MacroAdviser and have found that the “jobs and growth” package WILL NOT GENERATE NET INCREASES IN JOBS OR GROWTH in the long-term. The reason why has to do with the fiscal drag created by deficits offseting and eventually outweighing the improved incentives created by the tax cut.

William Gale: Thanks to all for a great set of questions.

That wraps up today’s show. Thanks to everyone who joined the discussion.

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