TCS Daily

What Will An Old Economy Tax Cut Do To The New Economy?

By Kevin Hassett - January 15, 2001 12:00 AM

Of all of the academic results I have seen over the years, the one that is most reliable is the positive correlation between a booming economy and the re-election of incumbents. Our politicians clearly believe in that link as well, which explains the frenzied atmosphere in Washington. Democratic and Republican leaders are rushing to craft a major tax cut that they hope will make sure that a possible recession will be over before voters have a chance to vote again.

Despite the rhetoric, almost all economists believe that it is imprudent to use tax policy to attempt to manage the business cycle. Indeed, whenever we have tried to use it in the past, the effort has blown up in our faces. The crucial observation is that recessions are typically very brief, lasting less than a year. Tax cuts often take a year to pass, and another year to affect actual returns. If we pass a tax cut in 2001, folks might use the extra money to buy an appliance in 2002. If, as many observers believe, we entered a recession in the fourth quarter of 2000, then the recession will be over before any consumption stimulus from the tax cut is felt.

This observation has not stopped policymakers before, and it likely will not do so this time either. It is not clear how the tax bill will shake out, but the first impressions suggest that it will resemble a garden variety old-economy personal income tax cut. Yet a recession, if we have one, will likely result from a wave of bankruptcies of new economy firms that are currently teetering close to the edge. Will old economy medicine undermine the health of our new economy patient?

Maybe. Here is a bad scenario that liberal opponents of tax cuts will likely emphasize in coming weeks. Congress passes a large tax cut that exhausts the budget surplus for a number of years. While taxpayers barely adjust their current consumption habits in response to the cut, financial markets begin to move immediately. Since the U.S. Treasury will have to rely more upon capital markets to raise funds, the supply of bonds increases significantly, which causes medium and long-term interest rates to jump. At the same time, the Federal Reserve, which has publicly opposed tax cuts in the past, keeps short-term rates high in defiance of the tax cuts. Firms that are close to the edge begin to go bankrupt because of the increase in the cost of funds, and these bankruptcies increase spreads on risky bonds. The higher spreads push even more firms into trouble, and a bankruptcy spiral begins.

My hunch is that this doomsday scenario will not happen for three reasons.

First, the Congressional Budget Office might be forecasting big surpluses, but the bond market probably has not fully accepted that forecast. If the bond market believes that surpluses left in Washington will be squandered on such wonders as the "Trent Lott Bridge," then a tax cut will have a very small effect on interest rates. Given the massive increases in spending that have accompanied surpluses in recent years, it is quite likely that the bond market is more skeptical about possible surpluses than our politicians appear to be. Indeed, if the tax cut slows the growth of government spending, it may even make it easier for the Federal Reserve to lower interest rates.

Second, whenever there is a tax bill, a million business measures that cut corporate taxes usually happen below the radar screen. For example, as we near recession, profits begin to dry up. When this happens, many firms get sucked onto the Alternative Minimum Tax (AMT), which is a second set of tax rules designed to increase taxes on firms if they have "too many" deductions. A stimulus package would likely provide some much needed AMT relief that would allow firms to keep deductions that they might otherwise lose. These tax cuts, if crafted cleverly, can put money in the pockets of even distressed businesses at just the right time.

Finally, while an income tax cut may not stimulate much consumption in the near term, it may provide a valuable cash infusion to small businesses. My colleague at the American Enterprise Institute, Glenn Hubbard, has shown that many of the so-called "wealthy" in the IRS tax files are entrepreneurs who get most of their income from operating small businesses. These businesspeople file their tax returns every quarter, and could receive significant and timely tax relief if Congress acts quickly, and cuts tax rates at the top.

On balance, then, the tax cuts that come out of Washington this year will likely benefit the new economy by providing cash to cash starved firms, and these benefits will likely be sufficient to offset any short term financial risks that are introduced because of lower budget surpluses. We will, however, have to keep a close eye on the debate, which has certainly not gotten off to a rational start. If class warfare conscious Democrats are able to defeat measures to steer some of the tax relief toward businesses, then the nightmare scenario will become more likely.

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