TCS Daily

Last Chance Boost

By Kevin Hassett - August 26, 2003 12:00 AM

Most observers agree that the Democrats are in trouble in the next election if the economy is strong. The latest economic data have suggested that the economy is at least headed in the "strong" direction, with initial claims for unemployment insurance, for example, heading below the 400,000 mark and staying there. A number of other risks remain, however, and a strong economy is no done deal. Interest rates have risen, profits have not recovered as much as one would like, and gasoline and natural gas prices have risen to threatening levels. Given these developments, Republican policymakers are doubtlessly asking their staff economists the question, "what can I do to make the economy as strong as it can be before November 2004?" How will the economists answer the question?


It is worth noting first that such an enterprise is not necessarily immoral. If good long run policy makes the economy hum and gets politicians reelected, then nobody needs to apologize.


So what might they do? If my own conversations with insiders are a good guide, the political strategists are likely to be very disappointed with what they hear. Studies of the impact of fiscal policy on the economy have generally found that the economy responds gradually to changes in tax and spending policy, with the full effect often taking more than a year to take hold. So think it through, imagine that a brilliant fiscal policy could be devised that might push activity from good to great, and passed as soon as Congress returns. The full effects of that policy will likely be in train by the end of next summer. Since we always observe the economy through the rear-view mirror, getting data a month to three months after the fact, we will only see the full effect of this immediate policy in the data just as the election is happening.


So if something is passed right away, and the thing passed is a wonderful policy, then we might expect to see the effect of it by next fall. Those are very big ifs. The political calendar is full of important unresolved issues (drugs are at the top of the list), and it is difficult to imagine that any new fiscal policy action could possibly make it the starting line this year. And the quality of policies passed lately has been less than perfect, with tax reductions with little incentive effects (child tax credits) as likely to pass as marginal rate reductions. If the debate is pushed off into next year, then the clock will have run out. For a typical tax bill, one can only expect to see passage in May or June. By then one might expect to see the full impact of the tax change sometime after the next election.


That does not mean, however, that the game is over. A look at the lineup of issues coming our way in the fall suggests that there will be one last chance to provide a meaningful reform that can add steam to the economy -- the repeal of the Foreign Sales Corporation rules being considered by House Ways and Means Committee Chairman Bill Thomas. On this issue, Chairman Thomas is legislating against a very tight clock, and failure to legislate may lead to stiff and economically meaningful trade penalties.


Here is why. We currently allow U.S. manufacturers to pretend that they have produced a product abroad when it is sold as an export. By doing this, it allows large manufacturers such as Boeing and Caterpillar to defer taxation in the same way that firms with foreign subsidiaries with actual operations abroad do. This tax trick has appropriately been ruled to be an illegal export subsidy and a violation of our trade treaties. Our trading partners will be allowed under our treaties to impose tariffs on U.S. exports if we leave the export subsidy unchanged.


Chairman Thomas has recognized that the repeal of the FSC will raise the cost of operation for U.S. manufacturers, and has put together a bill that allocates the revenues gained when the FSC tax trick is removed amongst revenue losing marginal rate reductions that are designed to stimulate investment and simplify the code. This tax vehicle has been making its way through the committee for some months now, and is likely going to be front burner in the next few weeks.


While one can expect the bill to mutate before it becomes law, the complicated tax provisions in it, by my calculations, lower the cost of capital for firms significantly. Normally, when tax changes lower the cost of capital, a commensurate increase in business investment follows. Many analysts have wondered whether the Thomas bill could pass given the strong motivation of its opponents (with Boeing and Caterpillar at the top of the list). My own guess is that Mr. Thomas will be able to get a compromise version of his bill moving once opportunistic politicians recognize that this bill is likely their last chance to affect the economy before the next election.


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