TCS Daily

Getting Recent Economic History Right

By Kevin Hassett - September 2, 2004 12:00 AM

NEW YORK --Yesterday at the convention, Vice President Dick Cheney affirmed the Republicans' view of recent economic history. President Bush inherited a recession and acted decisively to end it. But critics argue that the Bush tax cuts were poorly designed to end a recession and that alternative policies would have increased economic growth and job creation. The evaluation of the Bush tax policies is a crucial requirement for rational thought about the President's record. Who is right? Did they help or not? And who has the best plan going forward?

While there are so many possible alternative policies that it can make even an economists' head spin, one reasonable way to run the counterfactual would be to suppose that Democrats had won the policy debate back when the recession was beginning. They argued that the marginal tax rate reductions proposed by the President would not help the economy. One study even claimed that they would reduce growth. This harm would occur because of higher interest rates. The best way to increase growth, it was argued, would be to focus on short-run policies that stimulate activity but do not have a large long-run budget cost. Moreover, since a large share of the tax reduction goes to the rich, one might see little stimulus, since the rich do not live hand to mouth.

If we fast-forward from the early debate over the Bush tax cuts to today, we can see that the negative concerns were misguided. A recent study out of Princeton University has found that the tax cuts stimulated consumption, even that of the rich. This conclusion is consistent with the consumption theory of Milton Friedman, who argued long ago that consumers will consume a tax cut that they perceive to be "permanent" but not one they perceive to be temporary. There has also not been a sharp increase in interest rates. At this time in 2001, the ten year treasury note paid about 4.8 percent, today it pays about 4.2 percent.

So the critics were incorrect when they said the tax cuts would not stimulate the economy. What about the critics' policies. Might they have worked better? The two that seemed the most prominent back in 2001 were federal grants to the states, and a temporary payroll tax reduction. The aid to the states might have stimulated the economy, just as the increased government spending (especially on defense) must have. However, a large literature on the growth effects of government spending suggests that the effects of higher government turn negative after about a year. It would be hard to argue that aid to the states would have produced more jobs three years out. The payroll tax cut might well have stimulated consumption, but the Friedman theory would suggest that it would be less stimulative than a permanent tax cut. And the whole point of these half measures is that they will help us avoid soaring interest rates. Since interest rates did not soar, it is hard to imagine that we would be better off today had we pursued these policies.

The President pursued a second and third round of tax reductions as well. First, expensing rules were made more generous in order to encourage investment in plant and equipment. Second, dividend taxes were reduced, again in order to encourage investment, but also in order to encourage dividend payouts. Both policies appear to have worked, although the papers are still being written. In any case, once again, the main cost of these policies according to opponents would be soaring interest rates. These have not materialized.

So the statements by Vice President Cheney that suggest that an economy heading toward recession was turned around by the President's policies seem well supported by the data. But the policies do carry risks going forward. Since spending has run ahead of tax revenue, and can not do so forever, it is necessary that government either adjust spending growth or revenue growth to return fiscal policy to a glide path. Senator Kerry has paid lip service to addressing this problem. President Bush has yet to reveal his second term agenda, and his strategy for dealing with this issue. And the longer term challenge presented by soaring entitlements has also not been specifically addressed.

But the first-term record is promising. Solutions for the remaining economic challenges, such as private retirement accounts and strict spending caps, are not difficult to conceive of. Perhaps the President will begin to sketch an agenda that includes these tonight.

Kevin A. Hassett is director of economic policy studies at the American Enterprise Institute.


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